Question

1. If a price of normal good falls, its quantity demanded increases. Explain this phenomenon with substitution effect and income effect with an example.

2. If a household’s money income changes and prices do no change, what happens to the household’s real income and budget line? Explain with an example.

Answer 1

Answer 1.

Price falls from P1 to P2. Budget line changes from MN to MN'.

Good X is normal good, so fall in price leads to increase in demand. When price of good x falls, real income rises.

Initial allocation of good x and y is at point A on the initial indifference curve IC1.

Price effect is from X1 TO X2

Substitution effect is from X1 to X3

Income effect is from X2 to X3

PE=SE+IE.

Note-According to HOMEWORKLIB RULES first question is answered.