Question

1. Sim Card Lungu regards Caterpillars to be an inferior good for relish. Explain with the help of an appropriate diagram in the light of the income and substitution effects how Sim Card Lungu is going to react to a fall in the price of Caterpillars. [8 Marks]

2. Using appropriate diagrams, explain the equilibrium position of a pure monopoly. Using the same diagram(s), explain why a monopoly is considered to be sub-optimal. [7 Marks]

Answer 1

a. Suppose good X1 (caterpillar) is an inferior and good Y (relish) is a normal good. Now the initial budget line is AB and the initial indifference curve is IC1 which is tangent to the initial indifference curve IC1 at point O with respect to which quantity of caterpillar is q1. Now when the price of caterpillar falls, the budget line will rotate outward from AB to AC which becomes tangent to the indifference curve IC2 and the quantity of caterpillar declines from q1 to q3. Now this total movement from point O to point is the total effect which can be decomposed into a substitution effect and an income effect.

To understand the substitution effect, we will hold the real income M/P as constant. Hence the consumer will stay on the same indifference curve IC1. But as the price ratio has changed due to a fall in the price of caterpillar, consumers will stay on the budget line with the slope of the new price ratio. Hence we draw a hypothetical budget line DE which is tangent to the initial indifference curve IC1 at point M and parallel to the new budget line AC. Now the movement from point O to M or the increase in the quantity demanded of caterpillar from q1 to q2 is due to the substitution effect.

Now to understand the income effect, we will consider real income M/P as variable. Now as price of caterpillar falls, consumers real income M/P will increase. But as caterpillar is an inferior good, which means that demand for caterpillar will decline as income increases. Hence as here consumer’s real income increases, the budget line will shift rightward from DE to AC and the new budget line becomes tangent to the new indifference curve IC2 at point N, with respect to which quantity demanded of caterpillar will decline from q2 to q3 due to the income effect. And hence here the income effect will outweigh the substitution effect and as a result the quantity demanded of caterpillar will decline from q2 to q3.

Relish IC2 - MAJALI an q E B 22 ubstitution . effect Catubella Income effect cs Scanned with CamScanner

b. Here the following figure depicts the equilibrium position in case of pure monopoly. At equilibrium the marginal cost curve cuts the marginal revenue curve from below and the equilibrium price is found at a point where the MR= MC line cuts the demand curve. In case of pure monopoly, price lies above the marginal cost which results in efficiency loss or welfare loss and there is deadweight loss in the monopoly give by the area ABC.

Deadweight loss Mc Duard MR Quantity Scanned with CamScanner