Question

1. Clearly describe substitution effect and income effect for a fall in price for a normal good and an inferior good.

2. The utility function for a consumer utility is U=30Q₁^1/2Q₂^1/2. If the price per unit of Q₁ is Ksh10 and Ksh5per unit of Q₂, determine quantities Q₁and Q₂ that the consumer should have to maximize utility if the consumer Ksh 350 budgeted.

3. Assuming the two goods X and Y and two persons, analyze the exchange of goods between the two using the Edge worth Box framework indicating the Pareto efficient allocation.

Answer 1

Answering only first question

1)

normal good

initial BC rotates outwards to GH' from GH

both Substitution & income effect tends to increase consumption of normal good, post price fall

Inferior good

BC rotates outwards, Substitution effect raises the Quantity Demanded, while Income effect works in opposite direction

but Stronger substitution effect Dominates income effect