Maisha spends all her income on good X and good Y. As the price of good X increa

Question

Maisha spends all her income on good X and good Y. As the price of good X increases while the price of the price of good Y remains fixed, Maisha’s price-consumption curve is horizontal.

a) Let the price of good Y be $1 per unit and Maish’s income be M. Draw the diagram that illustrates the situation described above.

b) How does Maisha’s expenditure on good X respond to changes in the price of good X?

c) Is good X a complement or a substitute for good Y? Explain.

d) What is Maisha’s price elasticity of demand for good X? Explain.

Explanation / Answer

(a)

The above diagram illustrates the given situation. As the price of good X rises from PX to PX1, then the budget line shifts from AB to AC and the new optimum bundle is such that the price consumtion curve is horizontal. This implies that the consumption of good Y remained unchanged.

(b) The following equation always holds.

Exoenditure of Good X + Expensiture on good Y = Income.
Exoenditure of Good X = Income - Expenditure on good Y                                       ....(1)

The situation is such that as the price of good X rises while the price of good Y and income remain constant, the demand of good Y is constant.

Since the demand for good Y and the price of good Y is constant, the expenditure on good Y is constant. There is no change in income either. Therefore, equation (1) implies expenditure on good X is also constant.

(c) As the price of good X rises, the demand of good Y neither rises nor falls. This means good X is neither a complement of nor a substitute for good Y.

(d) As the price of good X rises, the expenditue on good X does not change. This means the demand for good X is unitary elastic.

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