Answer to Question #151663 in Microeconomics for zik

Question

Suppose Ace Albert spends all his personal income on only three commodities X, Y, Z. Assume that we know that X and Y are normal commodities and that X is a substitute for Y( in the sense that if Ace consumes more of X, he must consume less of Y in order to remain at the same level of satisfaction, ie on the same indifference curve)
i. Explain how the substitution and income effects operate on commodities X and Y when the price of X falls, ceteris Paribus
Explain under what condition will the cross elasticity of the two commodities be negative

Answer 1

When the price of X falls, ceteris paribus, the consumer buys more quantity of X and less quantity of Y because of substitution effect (if both of them are normal goods, people strive to substitute comparatively more expensive commodity by cheaper one) and because of income effect (if price of X falls, the purchasing power of income grows).

Cross elasticity of two goods is negative if they are complementary goods (when the price of first commodity falls, the demand for the second one rises).