Question

Xavier considers lemonade (X) and iced tea (Y) to be normal goods and has convex preferences.
a. (10 pts) Design an indifference curve-budget line diagram showing the substitution and income effects
created when the price of lemonade increases. In your diagram, place lemonade on the horizontal axis
and iced tea on the vertical axis. Identify the initial optimal choice as (X*, Y*) and the optimal choice
after the price increase as (X**, Y**).
b. (4 pts) How can you tell from your diagram that lemonade and iced tea are normal goods? Explain.
c. (5 pts) Using your diagram, does Xavier view these two goods as substitutes or complements? Explain.
(Note: answers may vary.)
d. (6 pts) In a new graph, draw Xavier’s demand curve for lemonade. Include both the initial choice and
choice after the price increase.

Answer 1

Part a) graph

Initial optimal choice : A

Optimal choice after price rise : C

Answer B)

Both are normal goods, bcoz as price rise, X Consumption falls & Y Consumption same or rise.

C) both goods are neither substitutes nor complements.

So the two goods lie between complements & substitutes.

Bcoz for this case, both income & substitution effect exist.

As for substitutes,no IE exists.

For complements , no SE exists.

D) demand curve is a downward sloping curve .

As after price rise, consumption of good X falls.