Answer to Question #240335 in Microeconomics for Kira

Question

Suppose you have an income of $24 and the only two goods

you consume are apples (x1) and peaches (x2). The price of apples is $4 and the price of peaches is $3. Suppose that your optimal consumption is 4 peaches and 3

apples.

a. Illustrate this in a graph using indifference curves

and budget lines.

b. Now suppose that the price of apples falls to $2 and

I take enough money away from you to make you as happy

as you were originally. Will you buy more or fewer

peaches? Provide a graphical representation.

Answer 1

Suppose We have an income of $24 and the only two goods that we consume are apples (x1) and peaches (x2). The price of apples is $4 and the price of peaches is $3 and the optimal consumption is 4 peaches and apples.

The above graph shows the peaches on the Y-axis and apples on the X- axis. It shows the optimum point of consuming both where the indifference curve equals to the IC at point E. BL is the budget line and IC is the indifference curve. 

When the price of apple falls to $2 then the budget line pivots outwards on the x-axis showing that as a result of the fall in price the quantity demanded of apple increases. If they take enough money away to make the individual as happy as he was originally then there will be a parallel backward shift in the budget line so as to keep the real income constant and the substitution effect will work according to which the individual will buy fewer peaches and more apples. This is shown by the Budget line B'L' and the equilibrium point E'.