Answer to Question #278906 in Microeconomics for legese

Question

 Suppose that price of one of the two goods increases while price of the other good and the total budget of the consumer kept unchanged. i) What is the consequence on the budget line and the purchasing power of the consumer? Explain logically with illustration. ii) Will the consumer be better off (be on the higher indifference curve) or worse off (be on the lower indifference curve)? iii) Show the changes in welfare in terms of income effect and substitution effect

Answer 1

Solution

i)

When the price of one good increases, there be fewer consumption opportunities available for the two goods and the slope of the budget line will decrease. The purchasing power of the consumer has fallen and the relative price of one good(first) is now higher while that of the other good (second) is now lower.

ii)

The consumer will be worse off, he/she will be on a lower indifference curve

iii)

The welfare of the consumer will change. Due to the increase in the price of the first good, the consumer will be forced to consume less of the first good and more of the second good ( with a relatively lower price). This leads to the substitution effect because the consumer has an incentive to consume less of the good with a relatively higher price(first good) and more of the good with a relatively lower price(second good).

The income effect is that a higher price implies that the purchasing power of income has been reduced (even though actual income has not changed), which leads to purchasing less of good ( First good).