Question

Suppose that a consumer consumes only two goods, coconuts and bananas. Suppose that the price of...

Suppose that a consumer consumes only two goods, coconuts and bananas. Suppose that the price of bananas increases.

A) Explain the direction of the income effect and substitution effect for both goods if both goods are normal goods.

B) What we say about the total change in the consumption of bananas if a banana is an inferior good?

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Answer #1

a)

Fall in price of Bananas can be analysed through income and substitution effects. Income effect would be positive here. In other words, rise in income shall lead to rise in demand for Bananas.

Substitute effect shall be negative. Both Income and substitution effects shall move in same direction. thus demand for Bananas shall rise and demand for coconuts would fall.

b)

Inferior good means demand for bananas is inversely related to income of consumer. Rise in income shall cause fall in demand for Bananas. Here, Income effect shall be negative and substitution effect would also be negative. Demand for bananas shall fall if negative income effect is strong enough to outweigh negative substitution effect.

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