Ii the income effect of the price change on bananas

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ii) the income effect of the price change on bananas. Ans: the increase in the price of bananas, with a fixed income and a constant price of scones, means that if Rajan chooses to purchase any bananas his real income is now lower than it was before the price increase - his budget set has shrunk. This is similar to a change in money income: the original optimal bundle is no longer attainable, and he must move to a new, lower, IC. The income effect of the price change on bananas reflects the change in quantity of bananas purchased as a result of the movement from the original to the new indifference curve. f) (4) Identify the effects in (e) on your diagram. Ans: substitution effect measured along original IC, from MRS = 6/5 to MRS= 12/5; income effect measured from original to new, lower, IC, with MRS=12/5.
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Name___________________________________________________________ Student number _________________________________ Lab LF0__________ Economics 203 (F01), 2005; midterm 1 Page 4 of 5 g) (5) If Rajan's income increased so he could just purchase his initial optimal bundle at the new prices, would he choose to do so? Explain why or why not (with reference to the diagram if you wish). Ans: No, he would not choose his initial bundle. The change in relative prices causes him to adjust his consumption to restore MRS = price ratio. Even if the original bundle is now just affordable, Rajan could attain a higher utility by purchasing fewer bananas, and more scones, than he originally did.
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