Question

3. (10%) In this question, we'll focus on Income and substitution effects. Consider the following three graphs, which Illustrate the preferences of three consumers (Bob, Carol, and Ted) regarding two goods, apples and peaches. Each consumer has an income of $30, and each consumer pays $2 for apples and $3 for peaches. a. Suppose that the price of peaches falls to $2. Draw a new budget line for each consumer and find the new optimal bundle chosen. How doe the new quantity of peaches compare to the original? Indicate the change in the first column of the table (e.g., an increase of one unit might be denoted as a +1). b. For each consumer, determine the substitution effect of the price change. How much of a change in peach consumption does the substitution effect account for? Indicate the change in the second column of the table. C. Now, add in the income effect. How much of a change in peach consumption does the Income effect account for? Indicate the change in the third column on the table. d. How does each consumer view peaches - as a normal or inferior good? (a) Bob (b) Carol (c) Ted Apples Apples Apples 6 7 8 9 10 11 12 131415 Peaches 5 6 7 8 9 10 11 12 13 1415 Peaches 7 8 9 10 11 12 13 14 15 Peaches Total Effect of Price change Substitution Effect of Price change Income Effect of Price Change Bob Carol Ted

Answer 1

	Total effect	Substitution effect	Price effect
Bob	+4	+1	+3
Carol	+1	+2	-1
Ted	+1	+1	0

(a) Bob (b) Carol (e) Ted Apples 15- Apples Apples 15 15 10- 10- 10 U2 1011 121314 15 4567891011 12131415 1234 19 1011 1213 14 15 Peaches Peaches Peaches

A. After price fall,

Bob consumes 9 peaches and 6 apples.

Carol consumes 6 peaches and 9 apples.

Ted consumes 6 peaches and 9 apples.

B. Substitution effect

For Bob, 6-5=1

For Carol, 7-5=2

For Ted, 6-5=1

C. Income effect

For Bob is 9-6÷3

For Carol is 6-7=1

For Ted is 6-6=0

D. For Bob peaches are normal good

For Ted peaches are income inelastic good

For Carol peaches are inferior good