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Maximizing Utility with Budgets
hard

In the context of maximizing utility with a given budget, which of the following scenarios best illustrates the substitution effect, while adhering to the utility-maximizing rule and considering opportunity cost?

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Choose the Best Answer

A

A consumer chooses to buy more of good X and less of good Y due to a price decrease in good X, while also considering the utility gained from the additional good X compared to the utility lost from less of good Y.

B

A consumer decides to spend their entire budget on good Y after realizing that good X provides more satisfaction at a higher price.

C

A consumer continues to buy the same quantities of goods X and Y even when the price of good X increases, as they believe utility is maximized at current levels.

D

A consumer evaluates the opportunity cost of buying an additional unit of good Y over good X and decides to stick with their original purchase plan.

Understanding the Answer

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Answer

The substitution effect occurs when a consumer changes their purchasing choices based on changes in prices, while trying to maximize their satisfaction, or utility, within their budget. For example, imagine a student who usually buys coffee and donuts for breakfast. If the price of coffee rises significantly, the student might decide to buy tea and a muffin instead, because these items are now relatively cheaper compared to the coffee. This change illustrates the substitution effect, as the student substitutes coffee for tea to maintain satisfaction without exceeding their budget. By considering opportunity cost, the student recognizes that spending more on coffee means giving up the chance to enjoy other tasty breakfast options.

Detailed Explanation

When the price of good X goes down, the consumer buys more of it. Other options are incorrect because This option shows a misunderstanding of utility; Here, the consumer doesn't change their buying habits despite a price increase.

Key Concepts

substitution effect
utility-maximizing rule
opportunity cost.
Topic

Maximizing Utility with Budgets

Difficulty

hard level question

Cognitive Level

understand

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