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In: Economics

Suppose you have a world with two goods, A and B. Suppose the price of good...

Suppose you have a world with two goods, A and B. Suppose the price of good B increases and good A is an inferior good. Explain, using concepts of income effect and substitution effect, how do you know that consumption of good A will increase. Suppose A was a normal good. Would consumption of A increase or decrease.

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Expert Solution

In a world of two goods. With increase in price of good B, substitution effect will lead to a decline in quantity demanded of B. Income effect will also lead a decline in quantity demanded of B since it is being assumed that B is a normal good. Since quantity of B reduces, hence, quantity of A will rise no matter it is a normal good or an inferior good. In both cases, quantity of A will increase.

Rahul Sunny answered 1 year ago
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