Question

_{1a. Consider two goods: x and y where y is a numeraire good. Suppose that x is a normal good. Graphically derive the demand curve for good x based on the indifference curve framework by working out the optimal consumption choices when the price of good x falls.}

_{1b. Rework 1a but now good x is an inferior good (but not a Giffen good).}

Answer 1

1a) Initially the budget line is AB. When price of good X falls, the budget line becomes AB' as consumers are able to sell more of the goods. In case of normal goods, more of the both goods are consumed due to income effect and consumer consumes at point B from point A while substitution effect says that more of only good X must be consumed whose prices have fallen which takes the consumer to point C.

1b) Initially the budget line is AB. When price of good X falls, the budget line becomes AB' as consumers are able to sell more of the goods. In case of inferior good, income effect works opposite. This happens because consumers does not respond by buying more of the goods when prices falls. Initially consumer is at IC1, reduction in price of good X cause him to consume at IC3 while income effect says that less of good X must be consumed which makes consumption at point IC2.