9. Income and substitution effects Rajiv and Simone Bertolli live in Dallas and

Question

9. Income and substitution effects Rajiv and Simone Bertolli live in Dallas and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves 11 and 12 represent two of their indifference curves for fancy dinners and diner breakfasts. They have $800 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 0 48 40 2 BC BC 0 2 10 FANCY DINNERS The initial budget constraint (BC1 ) shows the Bertollis' budget constraint when the price of a fancy dinner is $160. At this price, Rajiv and Simone would choose to consume two fancy dinners Suppose that the price of a fancy dinner decreases to $40, shifting their budget constraint to BC2, which represents a new relative price of four diner breakfasts per fancy dinner. (Hint: The blue line labeled H is parallel to BC2 and tangent to 1 at point B.)

Explanation / Answer

1) When price of fancy dinners is $ 160 then person consume bundle of 48 dinner breakfasts and 2 fancy dinners.

To consume this bundle after price change, consumer need 48 x 10 + 2 x 40 = 480 + 80 = $ 560

2) Better off

3)

4) Increase in real income

5) Normal good

Fancy Dinners Represented by... Consumption change Substitution effect A to B 5 - 2 = 3 Income effect B to C 10 - 5 = 5

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