9. Income and substitution effects Kevin and Maria Singh live in Dallas and enjo
ID: 1119966 • Letter: 9
Question
9. Income and substitution effects
Kevin and Maria Singh live in Dallas and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves and represent two of their indifference curves for fancy dinners and diner breakfasts. They have $400 per month available to spend on eating out. The price of a diner breakfast is always $5. Each labeled point represents the tangency between a budget constraint and the corresponding indifference curve.
Explanation / Answer
To consume at some point on the same indifference curve:
Income spent should be = 72 x 5 + 50 x 3 = $510 (They consume 72 diner breakfasts and 3 fancy dinners)
At the new optimal bundle, they are worse off than before the price change in fancy dinners.
In this case, the price increase in fancy dinners causes the Singh's real income to decrease. Because of the change to Kevin and Maria's real income and the direction of the income effect, fancy dinners are inferior goods for the Singh's.
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