Suppose our agent\'s income is $240. Only two goods exist for our agent, good X

Question

Suppose our agent's income is $240. Only two goods exist for our agent, good X and good Y. Good X costs $10 per unit and Good Y costs $12 per unit. Assume this agent has indifference curves that look like those typically drawn in class.

Now suppose the price of Good Y decreases to $8 per unit. The price of Good X is still $10 per unit.

A.Given this price change, and given the OCB you selected above, circle which of the following bundles could be Point B (where the change between the OCB and Point B represents the substitution effect):

(10 units X, 12 units Y)   (12 units X, 15 units Y)   (10 units X, 10 units Y)

B. Explain how you got your answer in part A.

Explanation / Answer

A.

Correct Answer:

(12 units X, 15 units Y)

After the price change of Good Y to be $8 per unit,

Income used = 12*10 + 15*8 = $240

B.

Due to substitution effect, consumption of that good, increases whose price comes down.

Here, X and Y are perfect substitute of each other.

Before the price change of good Y,

In consumption bundle,

Number of units of X = 120/10 = 12 units

Number of units of Y = 120/10 = 12 units

After the price change,

Number of units of X = 120/10 = 12 units

Number of units of Y = 120/8 = 15 units

Increase in the consumption of good Y, is due to the substitution effect.

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