1. Income and substitution effects Aa Aa Sam and Janet Zhou live in San Francisc

Question

1. Income and substitution effects Aa Aa Sam and Janet Zhou live in San Francisco and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the red curves U1 and U2 represent two of their indifference curves for fancy dinners versus diner breakfasts. Their total income to be spent on eating out is $700 per year. The price of a diner breakfast is always $10. The blue lines I1 and 12 represent their budget constraints if the price of a fancy dinner is $100 or $400, respectively. The green line H is parallel to 12 and is tangent to U1 at point Y. DINER BREAKFASTS PER YEAR U1 U2 70 60 -- 20 - 112 FANCY DINNERS PER YEAR

Explanation / Answer

1) When price of fancy dinners is $ 100 then Zhous spend 5 x 100 = $ 500

2) To consume bundle X after price increase, income required = 5 Fancy dinners + 20 Diner breakfast

= 5 x 400 + 20 x 10 = 2000 + 200 = $ 2200

3) X to Y shows substitution effect. So, 3 times per year.

4) Y to Z shows income effect. So, 1 time per year.

5) Normal good because decrease in income(disposable) causes decrease in consumption of fancy dinners.

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