Answer to Question #24511 in Economics of Enterprise for loide

Question

A consumer,John spends all of his income on 2 goods X and Y. The two goods are both normal but are not complementary. The price of good X is reduced but the price of good Y is unchanged. The consumer continues to spend all of his income on the two goods.

a.& Distinguish between the substitution effect and the income effect of price reduction in good X.
b. Explain three assumptions concerning consumer behavior.

Answer 1

a. If the price for good Y rises, John spends less money on it, so it spends more money on good X, so these goods may be
substitutes. Good X may have higher value for John, than good Y, so he spends
more money on it, using income effect.
b. So, the first assumption is, that the goods are substitutes. The other is
that there is no correlation between these goods and John only spends free
money for good X. Also the good X may have higher value for John, than
good Y, so he spends more money on it, using income effect.