Need clarification on this. 23. Charlie has standard (bowed in toward the origin

Question

Need clarification on this.

23. Charlie has standard (bowed in toward the origin) indifference curves for the only two goods he consumes, cereal and orange juice. When the price of cereal falls, Charlie buys more cereal and more orange juice than before. Which of the following must be true? i. The income effect on cereal outweighs the substitution effect on cereal as a result of this price change. ii. The income effect on orange juice outweighs the substitution effect on orange juice as a result of this price change A. Both(i) and ) are true. B. ii. The income effect on orange juice outweighs the substitution effect on orange juice as a result of this price change. C. Neither (i) nori) is true. D. i. The income effect on cereal outweighs the substitution effect on cereal as a result of this price change.

Explanation / Answer

ANSWER:

IF THE PRICE OF CEREAL HAS FALLEN AND STILL CHARLIE BUYS MORE CEREAL AND MORE OF ORANGE JUICE IT WILL BE DUE TO THE FACT THAT THE INCOME EFFECT WILL BE MORE THEN THE SUBSTITUTION EFFECT AND FOR THAT WE NEED TO UNDERSTAND WHAT IS INCOME EFFECT AND IT IS THE CHANGE IN DEMAND OF THE GGOD OR THE SERVICE EITHER BY THE CHANGE IN THE CUSTOMER'S INCOME OR THE PRICE OF THE GOOD DECREASING AND IN THIS CASE THE PRICE OF CEREAL HAS DECREASED A LOT AND THEREFORE CHARLIE IS ABLE TO BUY MORE OF CEREAL AND ORANGE JUICE.

WHAT IS SUBSTITUTION EFFECT ? IT MEANS THAT IF THE PRICE OF GOOD RISES OR THE INCOME OF THE CONSUMER DECREASES , THE CONSUMER WILL REPLACE THE CURRENT ITEM WITH ANOTHER ITEM.

NOW THAT WE HAVE UNDERSTOOD WHAT IS INCOME AND SUBSTITUTION EFFECT , WE CAN SAY THAT SINCE THE PRICE OF CEREAL HAS FALLEN HE HAS BEEN ABLE TO CONSUME MORE OF CEREAL AND ORANGE JUICE AND HENCE IT WILL BE DEFINED UNDER THE INCOME EFFECT AND SINCE WE DON'T KNOW WHAT HAS HAPPENED TPO THE PRICE OF ORANGE JUICE AND THE INCOME OF CHARLIE , WE CANNOT COMMENT ON THERE EFFECTS ON THE CHARLIE'S CONSUMPTION AND THEREFORE OPTION D IS RIGHT.

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