Suppose we have a two-good economy, and we know that good 1 is a normal good. Can we then make any meaningful observation about the demand for good 1 when we change the price of good 2 and keep the price of good 1 constant?
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$\begingroup$ This seems like a homework question. Please share your thoughts. $\endgroup$– GiskardCommented Oct 25, 2016 at 18:02
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2 Answers
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Check out the demand functions for three cases:
- CES Utility
- Leontief Utility
- Cobb-Douglas Utility
You should be able to see that the first case gives you that demand for good 1 increases, the second case demand for good 1 decreases, and in case 3 it is unchanged.
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If consumers make choices on a constrained budget, the marginal net utility derived from the consumption of the good 1 would be relatively higher than the good 2 after its price hike.
Thus, an indirect effect of the increase of the price of the good 2 would be an increase of the demand for good 1 as consummer preferences realign toward it.
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$\begingroup$ What if the goods are perfect complements that must be consumed in the ratio 1:1? Your reasoning would then imply that consumption of both 1 and 2 would increase, which is impossible if income is fixed and the budget constraint binds. $\endgroup$ Commented Oct 26, 2016 at 6:52
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$\begingroup$ Perhaps this isn't a point worth making, but are we assuming there is no saving/inter-temporal trading within this model (it is after all, explicitly a micro question)? $\endgroup$– bappers2Commented Oct 26, 2016 at 12:25
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$\begingroup$ @Ubiquitous: it is specified in the question that good 1 is a normal good, not a complement. If it was the case, the consumption of both goods would decrease as the price of good 2 goes up. $\endgroup$ Commented Oct 26, 2016 at 14:50
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2$\begingroup$ @CodingDahu a good can be both normal and a complement. Normal just means that demand is increasing in income. $\endgroup$ Commented Oct 26, 2016 at 17:07