Question

Two goods are in the consumer basket, goods X and Y. The consumer income is I, price of good X is Px, and price of good Y is Py. Use the consumer model to derive the demand curve for good X. Explain your answer in details.

b. Using your answer in part a, clearly explain and show the substitution effect and the income effect.

Answer 1

A. we think about the indifference curves in a slightly different way, we see that MRS describes marginal benefit. Since MRS represents the maximum amount of y we are willing to give up in exchange for one unit of x, it also represents how much value our consumer places on x in terms of y.

This means the indifference curve tells us the marginal benefit of good x in terms of good y, and the budget line tells us the marginal cost of good x in terms of good y. As discussed in Topic 1, using marginal analysis, our consumer will continue to purchase more of a good until the marginal benefit is equal to the marginal cost. This means

if MRS > Px/Py, the consumer will consume more x and less y.

If MRS < Px/Py, the consumer will consume less x and more y.

If MRS = Px/Py, the consumer will not change their consumption.

Recall that MRS is the slope of the indifference curve, and Px/Py is the slope of the budget line. This means that if the slope of the indifference curve is steeper than that of the budget line, the consumer will consume more x and less y.

B.The income effect expresses the impact of increased purchasing power on consumption, while the substitution effect describes how consumption is impacted by changing relative income and prices. ... Some products, called inferior goods, generally decrease in the consumption whenever incomes increase.