Question

Consider two goods with positive prices. The price of one good falls, while income and other prices remain constant. Show graphically what must happen to the size of the budget set as a result and why. (Show ALL work)

Answer 1

The two goods has positive prices.

Now, price of one good falls.

This fall in price of one good will increase the purchasing power of consumer with respect to purchase of this good.

This will enable the consumer to purchase more of the good whose price has decreased.

Following figure shows the graphical scenario -

At initial prices, budget line of consumer was AB. Now, price of Good X has decreased. Keeping other things constant, this will enable the consumers to purchase more of Good X in the given income.

Thus, budget line has rotated outward along the X-axis from AB to AB1.

The new budget line is AB1.

The area enclosed within budget line is referred to as budget set.

The area enclosed in budget line AB1 is greater than the area enclosed in the budget line AB.

Thus, the size of budget set has increased.