Suppose there are two goods in an economy, X and Y. Prices of these goods are...

Suppose there are two goods in an economy, X and Y. Prices of these goods are Px and Py, respectively. The income of the only agent (consumer) in the economy is I. Using this information, answer the following questions:

a. Write down the budget constraint of the consumer. Draw it on a graph and label the critical points accordingly. Provide a verbal explanation of why all income is spent, mentioning the underlying assumption for this outcome.

b. Define substitution and income effects.

c. Assuming both goods are normal, suppose Px goes down due to an excess supply of good X, whereas Py is held constant. Drawing a graph, show the substitution and income effects as well as the total effect of this price reduction. Explain the change in demands for the goods using the relation, where MU represents marginal utility. Be precise in labeling your graph and its step-by step explanation.

MUx / Px = MUy / Py

d. Looking at the sign of the total effect, discuss the relation between the price of a normal good and its demand.

e. Now suppose X is an inferior good. How does your answer to part (c) change? Drawing a new graph, comment on the signs of the substitution and income effects.

f. What is Giffen paradox? Drawing a new graph, discuss it in terms of the magnitudes of the substitution and income effects. How is the demand for a Giffen good sloped? Why? Provide the necessary definitions and explain it using the signs and magnitudes of substitution and income effects.

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Rahul Sunny answered 1 week ago

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