1a. Good X is a \"Normal Good\". Suppose that its price rises. In this case the

Question

1a. Good X is a "Normal Good". Suppose that its price rises. In this case the substitution effect makes agents purchase ________ of good X while/and the income effect makes the agents purchase ________ of good X.

A) less, less B) more, less C) less, more D) more, more

1b. A consumer only buys goods A and C. Therefore, his budged constraint is PAA + PCC = M 9) where M is income, and Pi, for i = {A,C}, is the price of each good. In order to draw the budget constraint in a graph with A on the horizontal and C on the vertical axes, you need to rewrite the budget constraint as:

A) A =-M/PA +(PC/PA)C

B) C=-M/PC+(PA/PC)A

C) A = M/PA - (PC/PA)C

D) C = M/PC - (PA/PC)A

1c. Only goods X and Y are available to a consumer. Determine the expressions for the utility maximizing allocation?

A) MRSxy = money income.

B) MRSxy = Px/Py.

C) Px/Py = money income.

D) MRSxy is at a maximum.

E) all of the above

Explanation / Answer

Answer)

1a) Substitution Effect simply means that in case of an increase in price of a commodity a consumer will start buying less of that commodity and will immediately shift to the purchase of a cheaper alternative, that is, substitution effect in case of a price increase will always lead to a fall in quantity and vice versa and therefore, the direction (sign) of substitution effect is always negative.

Hence, when X is a normal good and it's price increases the substitution effect makes the agent purchase "less" of good X while/and the income effect also makes the agent purchase "less" of good X as an increase in price will lead to a decrease in purchasing power resulting in a fall in the demand for normal goods.

Hence, the correct answer to 1a) is "option A that is less,less".

1b) A budget constraint simply indicates the different combinations of goods that a consumer, given his money income and the prices of different goods can purchase.

In the question above the consumer buys only two goods namely A and C and therefore, his budget constraint is,

PA.A + PB.B = M

In order to draw a budget constraint in a graph with A on the horizontal axes and C on the vertical axes, C needs to be solved in terms of A and rewritten as:

C = M/Pc - (Pa/Pc)A

Hence, the correct answer to 1b is "option D".

1c) A consumer gets maximum satisfaction or is in equilibrium when the ratio of the marginal utilities of the two goods equals the price ratio of the two goods. That is,

MUx/MUy = Px/Py

Where, MUx= Marginal Utility from good X

MUy= Marginal Utility from good Y

Px = Price of good X

Py = Price of good Y

And since, MUx/MUy = MRS the correct answer to 1c is option B. That is,

MRS = Px/Py.

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