Answer to Question #215855 in Macroeconomics for Chloe

Question

Iñigo divides his income between banana and bread. A typhoon damaged banana plantations causing a large increase in the price of bananas.

1.Show the effect of the typhoon on Iñigo’s budget constraint.

2.Show the effect of the typhoon on Iñigo’s optimal consumption bundle assuming that the substitution effect has the same extent of effect with income effect.

3.Show the effect of the typhoon on Iñigo’s optimal consumption bundle assuming that the income effect outweighs or dominates the substitution effect for bread.

Answer 1

1) lets take good X as bananas and Y as bread. Increase in price of bananas from A to B will make them expensive thus their consumption reduces.

2)

Banana and bread are normal goods and their substitution and income effect is positive. increases the quantity of bread consumedwill cause a shift of u₂ the curve to the right. This is because income effect is positive and quantity demanded is inverse with price.

3)

Increase in price bananas from A to B makes them expensive but income effect outweighs the substitution effect for bread .if Iñigo spends all the budget on bread alone he can buy C and if he spends all the budget on bananas alone he can buy D.