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 on the orange juice outweighs the substitution effect on cereal.

When price of cereal falls, substituion effect says that the demand for cereal would increase and the demand for orange would decrease.

A fall in price is like an increase in the purchasing power. So income effect says that demand for cereal will increase and demand for oranges will also increase.

Since Charlie is consuming more ornages than before, this means that income effect outweighed substitution effect.