Question

Homework (Ch 21) 9. Income and substitution effects Andrew and Beth Trimble live in Philadelphia and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves I, and I, represent two of their indifference curves for fancy dinners and diner breakfasts. They have $1,000 per month available to spend on eating out. The price of a diner breakfast is always $10. Each labeled point represents the tangency between a budget constraint and the corresponding indifference curve. ? N 0 DINER BREAKFASTS 90 M IL BC BC2 56 8 FANCY DINNERS

Answer 1

(1) Initial utility-maximizing point is L (with dinner = 5, breakfast = 50) for budget line BC1, and after price decreases, utility-maximizing point is N (with dinner = 6, breakfast = 70) for budget line BC2.

The blue line is parallel to BC2, intersecting I1 at point M (with dinner = 8, breakfast = 30). At this point, utility is equal to utility at point N, but at new prices.

Cost at point M ($) = 10 x 30 + 50 x 8 = 300 + 400 = 700

(2) At point N, they are better off since it lies on a higher indifference curve.

(3)

	Represented by	Consumption change
Substitution effect (SE)	Movement from point L to point M	8 - 5 = 3
Income effect (IE)	Movement from point M to point N	6 - 8 = - 2

(4) Price decreases causes real income to increase. Fancy dinners are Inferior goods. (Since SE > IE, so consumption of dinners increase as net effect)