Question
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(In this question we denote income by Y, not by W as in the lecture notes). The following figure shows the consumption of x and y for two market situations.

The income effect of a change in price of x from px to px’ is?

Negative and is dominated by the substitution effect.

Positive and reinforces the substitution effect.

Negative and dominates the substitution effect.

Negative and reinforces the substitution effect.

Positive and dominates the substitution effect.

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Step 1

The correct alternative is Negative and dominates the substitution effect.

Step 2

To determine: Income effect of a change in price of good x from Px to P’x.

Step 3

Here, “x” is the initial combination of good x and as the price of good x declines, the budget line will shift outwards from Y/Py to Y/Px. Furthermore, now indifference curve will shift to the...

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