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

When the price of cereal falls, people would like to consume more cereals and less orange juice. That is by substitution effect the consumption of cereals will be increased and the consumption of orange juice will be decreased.

When the price of cereals falls, real income is increased so people would like to consume more of both products.

If income effect dominates the substitution effect then the consumption of both products will be increased.

So the income effect on orange juice outweighs the substitution effect on orange juice as for income affect the consumption of orange juice will be increased.

Option A is correct.