Answer to Question #248177 in Microeconomics for hgh

Question

Rakhi likes to consume only two commodities X and Y, and nothing else. Both the commodities give her positive utilities, thereby giving rise to her preferences being wellbehaved and convex. However, she treats commodity X as an inferior good. Suppose Rakhi earns an income of 1000 per month and the ongoing prices of commodities X and Y are 20 and 10, respectively. a) Show, with the help of a diagram, what will happen to her optimal consumption of commodity X, in each of the following circumstances: i. Situation A: Price of X falls to 10, while everything else remains the same. (1.5 marks) ii. Situation B: Her income increases to 2000, while prices remain the same. (1.5 marks) b) What can you say about the demand curve for commodity X that Rakhi’s choice behavior would produce? Elaborate. (2 marks) Use diagrams to support your answers.

Answer 1

Solution:

a.). i.). When the price of X falls, there will be both income and substitution effect since good X is inferior. When it comes to inferior goods, the income effect works in the opposite direction of the substitution effect. When the price of an inferior good falls, the negative income effect tends to reduce the quantity purchased, whereas the substitution effect tends to increase the quantity purchased. However, it is common for the negative income effect of a price change to be insufficient to outweigh the substitution effect. As a result of a decrease in the price of good X, the substitution effect, which always induces the consumer to buy more of the good whose price has decreased, will usually outweigh the negative income effect. Thus, even in the case of inferior goods, the net result of a price decrease will be an increase in the quantity demanded.

 

This is displayed by the below graph:

 

ii). When her income increases to 2000 while prices remain constant, her budget line will shift from BL₁ to BL₂, parallel to the original budget line. This is because, with increased income, she will be able to purchase a proportionately larger quantity of good Y and X than previously. But since good X is an inferior good, she will purchase more of good Y than good X at point E₂.

 

This is displayed by the below graph:

 

 

b.). The demand curve for commodity X shifts inwards when income increases since the demand for the commodity decrease as consumer income increases.