14. In the tollowing graph the consumer begins in equuiorin with an income o $5,

Question

14. In the tollowing graph the consumer begins in equuiorin with an income o $5,000, facing the prices S50 and -$25. 200 120 0 50 80900 150 250 Quantity of x a. In equilibrium, units oEX are consumed. Now let the price of X fall to $20, income and the price of Y remaining constant. 6 In the new equilibrium, units of X are consumed c. In order to isolate the substitution effect, $.must be taken away from the consumer. The total effect of the price decrease is d. The substitution effect is . The income effect is .

Explanation / Answer

a) Equilibrium is at the point where the budget line is tangent to the indifference cure. Thus in equilibrium 50 units of X are being consumed.

b) When price of X falls to $20, then consumer will consume more of X. In the new equilibrium the consumer is consuming tangency point of the new budget line indifference curve 2. Thus the consumer is consuming 80 units of X.

c) To isolate the substitution effect we compensate the consumer so that he buys the the same amount X as before the fall in price. So in order to buy 50 units of X at the new price of $20 is = (50-20)*50=$1500 should be taken away from the consumer because at the new price only $1000 is required to buy 50 units off X (given he is consuming 100 units of Y).

d) The total effect of the price decrease is 80-50=30 and total effect=substitution+income effect. When $1500 is taken away from the consumer, then he consumes 90 uniits of X. So the substitution effect is 90-50=40 and the income effect is 80-90=-10

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