Question

i need the checklist completed and answered clearly, we didnt go over this in class and this is all the information my teacher gave us for this problem on the homework, make the answer easy to read. the graph and how getting the graph is the most important

Please only use a PDF! All other types receive zero points! Method 1: Most programs have a feature to "save as" then select PDF. You can do this from MSword in the computer lab! Method 2: Print and then select a PDF printer (Not all computers can do this!) I. You have a monthly income of 800 dollars. You want to spend your income on party drinks and new dance music. The price of party drinks are 4 dollars each. New dance music costs 1 dollar each. Draw your budget constraint and a reasonable indifference curve. On the same graph, show what would happen if the cost of new dance music increased to 2 dollars each with a new budget constraint and indifference curve. Illustrate how the change in quantity breaks down into the substitution and income effects. Short Answer Submission Checklist: O Hand Draw your graph. O Label both axis and all curves properly O Make sure the quantities on the axis for the budget constraint are O Bake sure you have properly illustrated which part is income and which part is substitution effects. O Make sure the lines are CLEAR as to where you found the demarcation point and how you found it. rrect. DELL

Answer 1

Let us assume dance music as Good X and Party drinks as good Y.

Monthly income = $800 Case I P drink = $4 P music = $1 . Let & n equ .. quantity of party drinks = Y n " dance music = x for Budget constraint : (4xy) + (1xx) = 800 4y = -x+800 Bt = Party Drinks 200 10. >x 200 400 8O Dance music

case 2] when $ 25 Prusic = Paraink = $ 4. .. (2xx) + (4xy)- 800 | 4y= –2x+800

If the price of dance music rises, then the budget line will pivot inwards around the point where it crosses the vertical axis. At the vertical intercept, the consumer is spending all his money on “part drinks” and not buying any of good dance music, so a price change in good dance music won’t change anything. But the horizontal intercept will be different, as the consumer is then spending all his money on good dance music, which is now more expensive, so obviously he can afford less given his budget.

Party Drinks 200 xx 180 400 800 Dance Music Let originally, optimal bundle A (400, 10o) Later: optimal bundle B (180, 120)

Here at the original budget constraint of B1, the optimal bundle is at A, where the consumer has 400 of good X and 100 of the good Y. When the price of X increases, the budget line shifts to B2. Here the optimal bundle is at B, where the consumer is consuming less of good X and more of the good Y.

Two things have gone on here. There is a substitution effect whereby the consumer is deciding to substitute some of good X for some other goods because X is now more expensive relative to other goods. There is also an income effect whereby the fact that X has got more expensive whilst other goods are unchanged in price, means that the consumer is now relatively poorer than he was before, his money doesn’t go as far.

To show how much of the overall change in spending on the different goods is due to the substitution effect, we consider what would happen if we were ‘compensating’ the consumer by giving him enough of a raise in income to allow him to stay at the same level of utility as he was on at bundle A, now that good X has become more expensive.

We can break down the substitution and income effects like this:

party A-B: A-c: Total Effect Substitution Effect Drinks IC-B: Income effect 110 B1 28. 200 400 600 doo Dance Music Income effect Substitution effect Total effect

Here we have drawn a new budget line (the black dashed line) with the same slope as the final budget line (B2), indicating the same relative prices between X and other goods as the final relative prices after the price change. This has been moved to the point that is tangential to the indifference curve that the original bundle, A, was on. Now this budget line effectively represents an increased budget, because it is a parallel shift outwards from B2. It shows us the budget that the consumer would have needed, to stay at the original level of utility, the same indifference curve as he was on at bundle A. However A would not be the optimal choice bundle here, it would be bundle C. Bundle C gives the same level of utility as bundle A, but it would satisfy the new relative prices after the price change. This shows us the substitution effect. If the consumer was compensated by being given enough raise in income to allow him to stay at the same level of utility as he was on at bundle A, he would have responded to the change in relative prices by shifting his spending to buy less good X and more other goods, hence the move from A to C.

The rest of the effect is the income effect. The shift from C to B, where the consumer has less money to spend on good X and also less money to spend on good Y, is as a result of the income effect of the price change making him poorer overall.