23 Charlie has standard bowed in toward the origin indiffere

23. Charlie has standard (bowed in toward the origin) indifference curves for the only two goods he consumes, cereal and orange juice. When the price of cereal falls, Charlie buys more cereal and more orange juice than before. Which of the following must be true? i. The income effect on cereal outweighs the substitution effect on cereal as a result of this price change ii, The income effect on orange juice outweighs the substitution effect on orange juice as a result of this price change. A. ii. The income effect on orange juice outweighs the substitution effect on orange juice as a result of this price change. B. Both (i) and (ii) are true. C. i. The income effect on cereal outweighs the substitution effect on cereal as a result of this price change. D. Neither(i) nor (ii) is true.

Solution

The income effect of the orange juice outweighs the substitution effect on orange juice.

When price of cereal falls, Substitution effect says that demand for cereal will increase and demand for oanges will decrease, keeping purchasing power cosntant.

When this purchasing power is increased, income effect says that increase in income will increase demand for cererals and demand for oranges will aslo increase, keeping prices constant at new levels.

Since demand for oranges has increased, income effect has outweighed substitution effect in this case.