Problem Set 3 Solutions

This implies there is no substitution effect and the

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Unformatted text preview: ge. This implies there is no substitution effect and the increased demand results only from the income effect. Y Current BC BC utility compensated BC after price change We start at point A on indifference curve U0 and with the steep budget constraint (dotted). The consumer chooses bundle A because the MRS < Px/Py (the ratio of marginal utilities is less than the ratio of MCurr A prices). Then Px decreases and we draw two new budget lines, MUtil one tangent to the original U0 U1 indifference curve and the other reflecting the original wealth and B C new price of good X. In both X cases the consumer only consumes good X (MRS > ratio of prices). The substitution effect is the quantity from the origin to C, while the income effect is from C to B. Other cases: Note that if the MRS is smaller than the price ratio before and after a change in Px, then there is no change: both the income and substitution effects ar...
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