Question

Assume a balanced utility allocation amongst all purchases. In one instance, the price of one good decreases. This results in utility/dollar increasing so that MU1/$<MU2/$.

A. How will the decisions of the consumer now change in regards to purchasing?

B. In regards to the Income/Substitution Effect, what is going on here?

Answer 1

Answer to Q. No. A

When due to change in the price of one good, MU derived from one good is not equal to the MU derived from other good i.e. MU1<MU2 as in the case of the above question. The consumer will now start buying 2nd commodity. When the consumer will buy 2nd commodity more than 1st commodity, MU derived from the 2nd commodity will decrease. He will keep consuming the 2nd commodity till the point where MU derived from both the commodities becomes equal.

Answer to Q. No. B

Income effect is the change in demand of a consumer due to change in his real income. Income effect occurs when the buying power of the consumer changes and he changes his demand on the basis of his changed buying power. When the price of a commodity changes it changes the real income of the consumer i.e. if price of a commodity decreases real income of the consumer increases and vice-versa.

In the above question, income effect is going on as due to change in the price of the commodity demand pattern of the consumer is changing.