Herbie consumes two goods and his utility function is U(x₁, x₂)  x³₁x⁴₂.The price of good 2 does not change and his income does not change, but the price of good 1 decreases.

A) The substitution effect of the price change reduces the demand for good 2 and increases the demand for good 1.
B) The substitution effect reduces the demand for good 2, and since the income effect is zero, the demand for good 2 falls.
C) The substitution effect on the demand for good 2 is zero, since the price of good 2 did not change.
D) The income effect is zero, since his income remained constant.
E) More than one of the above statements is true.

Question

Sumeyah Mohamed · Accepted Answer

Final Answer : A, Explanation :  According to the law of demand, a decrease in the price of good 1 will increase the quantity demanded of good 1, ceteris paribus. This is the substitution effect. Because Herbie's utility function is such that he consumes both goods, an increase in the quantity demanded of good 1 will reduce the expenditure on good 2, hence the substitution effect reduces the demand for good 2. Therefore, statement A is true. Statement B is false because the substitution effect does not necessarily reduce the demand for good 2 and the income effect is not necessarily zero (it depends on the nature of the good and the shape of the indifference curves). Statement C is false because the substitution effect does affect the demand for good 2 indirectly via the demand for good 1. Statement D is true but not relevant to the question, because the price of good 1 changed but the income did not.

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