Perfect substitutes. MRS=a Given the prices and income P1, P2, and I, solve for the consumer’s optimal choices?
Ans. If the goods are perfect substitutes, the consumer will spend all his income on the good which is relatively cheaper and at equilibrium,
Marginal Rate of Substitution = Price of good 1 / Price of good 2
=> a = P1/P2
So, there are three cases for equilibrium,
i) a > P1/P2 (i.e. P1 < P2), consumer will consume only good 1 because it is cheaper, so,
demand function for good 1 is x1 = I/P1
and demand function for good 2, x2 = 0
ii) a < P1/P2 (i.e. P1 > P2), consumer will only consume good 2 because it is cheaper, so,
demand function for good 1, x1 = 0
and demand function for good 2, x2 = I/P2
iii) a = P1/P2 (i.e. P1 = P2), consumer will be indifferent between the two goods and can consume any quantity of x1 and x2 on the budget constraint.
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