Question

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]

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

When the price of a its demand changes l.e. the effect that a good has on the good changes, then how is known as price effect the change in price of demand for that good. Cenerally when the price of a good falls, its demand increases as per the law of Demand. But when we have an inferior good, then the law of demand might not hold i.e with a fall in prices its demand might not increase by as much amount as it would have increased for a normal good. Price effect can be studied as a combination of substitution effect and income effect. When the price of a good falls, the consumer tends to consume more of that good by substitution it in place of other goods . This is known as substitution effect . When the price of a good falls, then the consumer can purchase more goods as his/her purchasing power has increased which is same as a rise in income. So this increase in consumption of a commodity due to increase in purchasing power is known as income effect. Sum of substitution effect and income effect gives price effen substitution Effect + Income effect - Price Effect

here Sim Card Lungu regards catterpillars as as inferior good. The effect of a fall in price of catter pillars on his demand for catterpillars can be understood in terms of income and substitution effect with the help of the following diagram. amount of all other goods IC2 IC, BL amount of catter pillars IT ax, E 641 SE it Recente E, Here IC, = Indifference cove/ I = Indifference Corne2 BL, = Budget line / BL₂ - Budget line 2 S.F. = Substitution Effect I. E. = Income Effect P. E. = Price Effect

Consider, I DE was the original Budget line of sim Card Lungu. After a fall in the price of catter pillar there is a pivotal shift of his budact line as now he can consume more of catter pillars while he can still consume the same amount of all other goods if he spends his entire income on them so the horizontal inter cept increases while vertical intercept remains the same. originally the consumer was consuming at point A (the point at which his IC was tangent to the original budget line) and he was consuming ox, amount of catter pillars. Now, with a fall in the price of catter pillars, he can consume more catterpillars even while remaining at the same utility level. So be will substitute catter pillars for other goods and will now start i consuming at point b. So he will consume ox amount of catterpillars. Therefore by the substitution effect, with a fall in prices, his consumption of catter pillers has increased. Therefore substitution effect is negative, ut i since the price has fallen, sodris purchasing power has increased which is same as an increase in income. With this increased income, he can either consume more catter pillers or can consume more amount of all ather goods. Since he considers catter fillars to be inferior goods, so with an increase in income, he will decrease wis consumption of catter pillars. So now he will start consuming on point C i.e. he is consuming Ox, amount of

Catterpillars. This is known as income effect. Here income effect is positive as with a fall in prices, his consumption of the inferior good das decreased. The net price effect in this case is the sun of the negative substitution effect and the positive income effect . In the case of inferior goods, income effect is positive while substitution effect is always negative, but the income effect is not as positive so as to over power the negative substitution effect to the net price effect in case of inferior goods will be negative or te with a fall in prices, its consumption: will increase The net price effect in case of inferior goodle might be ambiguous but in most cases it will be negative i.e. with a fall in prices, consumption of inferios goods will increase but by a very small amount. So ultimately the will more from A to c which is the net price effect. (-) (+) Cambiguous)

Price effect is a sum of substitution effect and income effect. Substitution effect is always negative while income effect in case of inferior goods is positive but the positive income effect is not large enough to overpower the negative substitution effect, so net price effect in case of inferior goods is negative. So with a fall in price of inferior good, it's consumption will increase but by a small amount as opposed to the case of normal goods. This is explained with the help of a diagram above.