Question

You consume two goods, X and Y . On Tuesday, the price of Y (not X!!) rises. On Wednesday,
there are no new price changes, but your income rises until you are just as happy as you were
on Monday.
a) Draw your budget lines and optimum points on all three days. Label the optima M, T and
W.
b) In terms of the locations of the optimum points, what would it mean for Y to be a Giffen
good?
c) In terms of the locations of the optimum points, what would it mean for X to be a normal
good?
d) Suppose that X is a normal good, and suppose also that you consume more X on
Tuesday than on Monday. When the price of Y changes, which effect on your
X-consumption is larger: the income effect or the substitution effect? Justify your answer
in terms of the locations of the points on your graph.

Answer 1

a. When the price of Y rises on tuesday, consumer will be able to consume less of it. However, the consumption of good X remains the same. Accordingly, the budget constraint will shift downward from AB to A'B.

Now, on Wednesday, when the consumer's income start rising, the budget line will shift in a parallel manner in the forward direction from A'B to LM. Since our consumer is as happy as in Monday, the budget line should pass through the optimal bundle he chose on Monday.

The optimal bundle on Wednesday can be the bundle same as he chose on Monday or any point to the right of it (because that part represents higher budget constraint.)

b. Given the optimal bundles we chose, Y is not a giffen good. Y would be a giffen good if its quantity demanded shows a positive relationship with price level. In other words, price level rises, the quantity demanded of giffen goods also rise.

c. X is a normal good according to the points we have taken. This is because, the quantity demanded of X increased as the income of the individual increased.

d. When the price of Y changes, and we consume more of X from Xm to Xt, it implies the dominant role of substitution effect. This is because we are consuming more of Y because it has become relatively cheap for us as compared to the good y and we are substituting the consumption of y with more of good x. Hence, substitution effect is dominant.