. The demand curve for a normal good will always slope downward because: 

i. the substitution effect and the income effect reinforce each other, and the substitution effect always displays an inverse relation between price and quantity demanded.

 ii. the substitution effect and the income effect reinforce each other, and the income effect always displays an inverse relation between price and quantity demanded. 

iii. even though the substitution effect and the income effect move in opposite directions, the substitution effect dominates, and it always displays an inverse relation between price and quantity demanded. 

iv. even though the substitution effect and the income effect move in opposite directions, the income effect dominates, and it always displays an inverse relation between price and quantity demanded.

 v. none of the above. 

b. Illustrate your answer with a two-good graph for two normal goods, showing the substitution and income effects resulting from a price rise for good 1. Explain in words. 

c. Now draw the two-good graph for two normal goods, showing how the optimal bundle changes as the price rises twice - you don't need to show the income and substitution effects, only the net result. 

d. Now draw thedemand curve for good 1, derived from part c. 

e. Explain parts d and e in words. 

 

2. a. Emma lives on Diet Pepsi and sushi, which are both normal goods. She learns Tomo restaurant has reduced its prices on sushi. Illustrate what happens to Emma's optimal consumption bundle on a graph with sushi on the horizontal axis and Diet Pepsi on the vertical axis. Carefully explain the income and substitution effects.

 b. Sadly, Tomo goes out of business. Emma now consumes only Diet Pepsi and ramen noodles, which are an inferior good to her. Morton Williams, noticing the lack of competition, increases the price of ramen noodles. Illustrate what happens to Emma's optimal consumption bundle on a graph with ramen noodles on the horizontal axis and Diet Pepsi on the vertical axis. Carefully explain the income and substitution effects. You may assume that the substitution effect is larger than the income effect. 

 

3. Are these goods likely to have a small or large substitution effect and a small or large income effect from a price change? Explain why.

 a. salt 

b. housing

 c. theater tickets 

d. food 

 

4. The demand curve shows what happens to the quantity of x1 consumed as p1 changes, holding p2, I and preferences fixed. Draw a demand curve for a good. In separate graphs, show how the demand curve will shift in response to: a. an increase in income. b. an increase in the price (p2) of a substitute of the good. c. a reduction in the price (p2) of a complement of the good.