Assume you have the utility function U( X; Y ) = XY: You have 20 liras...

Assume you have the utility function U( X; Y ) = XY: You have 20 liras to spend. Price of good X is a lira per unit and price of good Y is a lira per unit. Given this information, you can solve for optimal consumption bundle and conclude that consuming 10 units of X and 10 units of Y maximizes your utility. Now assume that price of X increases to 2 liras. Price of good Y is constant and your income is still 20 liras. Now,the new optimal consumption bundle is 10 units of Y and 5 units of X. We observe that good X consumption declines from 10 to 5. This is what we call as total e§ect. Decompose the decline in X consumption into income e§ect and substitution e§ect. Decompose numerically. Explain your answer using a graph as well. (I want you to be able to say for example " the decline in X consumption is 5 units. 2 units is due to substitution e§ect and 3 units is due to income e§ect )

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Rahul Sunny answered 8 months ago

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