1. (a) Suppose you spend all of your income on apples and oranges, which are bot

Question

1. (a) Suppose you spend all of your income on apples and oranges, which are both normal goods and which are imperfect substitutes. If the price of apples increases, will you consume more or fewer apples as a result of the substitution eect? What about the income eect?

(b) Suppose you consume two goods: Ramen and Starbucks coee. Ramen is an inferior good and Starbucks coee is a normal good. The price of Ramen increases. Assume Ramen is not a Gien Good. What happens to your consumption of Ramen due to the substitution eect? The income eect? What is the net eect on Ramen consumption?

(c) Now assume Ramen is a Gien good. What happens to your consumption of Ramen due to the substitution eect? The income eect? What is the net eect on Ramen consumption?

Explanation / Answer

a).

Consider the given problem here these are two goods “apples” and “oranges” and both of them are normal goods. Now, as the price of “apple” increases, => “apples” got relatively expensive compare to the “oranges”, => “substitution effect” induce the consumer to purchase less of “apples” and more of “oranges”. So, “SE” reduces the consumption of “apple” and increase the consumption of “orange”.

Now, as we can see that as the price of “apples” increases, => the purchasing power of that consumer also decreases, => “Income Effect” induce the consumer to purchase both of these both less compare to before. So, due to “IE” the consumer reduces both the consumption of “apples” and “oranges”.

b).

Suppose there are two goods “Ramen” and “Starbuck coffee” where the former is “inferior” but not “giffen” and the latter is normal good. Now, as the price of “Ramen” increases, => “Ramen” got relatively expensive compare to the “Starbucks”, => “substitution effect” induce the consumer to purchase less of “Ramen” and more of “coffee”. So, “SE” reduces the consumption of “Ramen”.

Now, as we can see that as the price of “Ramen” increases, => the purchasing power of that consumer also decreases, => “Income Effect” induce the consumer to purchase more of “Ramen”, as it’s an “inferior” good. So, due to “IE” the consumer increase the consumption of “Ramen”.

Now, since “Ramen” is an inferior good but not giffen, => “SE” is stronger than “IE”, => over all the effect will be negative, => as the price increases implied the quantity of consumption of “Ramen” decreases.

c).

Now, assume that this time “Ramen” is an “inferior” as well as “giffen” good, => the effect of “SE” and “IE” will be same as before on the consumption of that good. But this time as “Ramen” is an “inferior” as well as “giffen” good, => “IE” is much stronger than “SE”, => here the net effect will be positive, => as the price of “Ramen” increases leads to increase in the consumption of “Ramen”.

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