Question 1

Suppose that there are two goods, X and Y, with prices P X>0 and P Y>0 and a consumer with income M0, who has hammock-shaped indifference curves and consumes both goods in positive quantities. Suppose that there is a decrease in the price of X.

(a) Using plain language, provide an answer to the following questions: Will the consumer be better-off or worse-off in response to this change? If we want the consumer to have the same change in welfare, but instead of obtaining it with a decrease in the price of X, we change her income, should we increase or decrease her income?

(b) Provide a graphical representation of the equivalent variation of the decrease in the price of X in our typical two-dimensional graph representing consumption bundles (with X in the horizontal axis and Y in the vertical axis)