Assume a consumer is currently purchasing a combination of goods, X and Y, that

Question

Assume a consumer is currently purchasing a combination of goods, X and Y, that maximizes her utility given her budget constraint, i.e., MUx/MUy = PX/PY. Now assume that there is a decrease in the price of Y. In this case, to once again maximize her utility, the consuemr will want to adjust her purchases of X and Y such that:
A) the marginal rate of substitution of X for Y, i.e., MUx/MUy, decreases
B) the marginal rate of substitution of X for Y, i.e., MUx/MUy, stays the same
C) the marginal rate of substitution of X for Y, i.e., MUx/MUy, increases
D) none of the above. The consumer will continue to maximize her utility after the price change by continuing to consume the same combination of X and Y.

As a result to the consumers adjustment to the change in the price of Y, assuming Y is a normal good and X and Y are complements, it is reasonable to expect that the amount of Y consumed will _____________, and the amount of X consumed will _________.
A) increase; decrease
B) decrease; decrease
C) increase; increase
D) cannot be determined; cannot be determined

Explanation / Answer

For the first question, the correct answer is: C) the marginal rate of substitution of X for Y, i.e., MUx/MUy, increases If the price of Y falls, then PX/PY will increase. In order for MUx/MUy = PX/PY, MUx/MUy must increase. For the second question we know that the a fall in the price of Y will cause more of to be consumed. The fall in price has two effects on X. First, a fall in price will increase the consumer's income, inducing the consumer to purchase more X. We call this the "income effect." Second, the fall in price of Y will cause consumers to substitute away from X and toward Y, causing consumers to purchase less X. We call this the substitution effect. Typically, the substitution effect dominates because Giffen Goods do not exist. So, the net effect is that consumers will purchase less X. A is the best answer.

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