The last two answers, for the first box is increased or decreased. For the last

Question

The last two answers,
for the first box is increased or decreased.
For the last box is an inferior good or normal good

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6. Income and substitution effects Clancy and Eileen Chen live in New York City and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves / and l2 represent two of their indifference curves for fancy dinners and diner breakfasts. They have $500 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. 67 . 0r Ir 5 7 8 FANCY DINNERS

Explanation / Answer

(1) R to S

Substitution effect is graphically depicted by a parallel shift of the new budget line which touches the original indifference curve (this ensures that utility remains at the original level). A movement from R to S depicts this.

(2) 1 less

Consumption change = 8 - 7 = 1

(3) Negative

Substitution effect is always negative, which is here justified by decrease in consumption.

(4) S to T

Total effect of the price increase = Movement from R to T

Substitution effect = R to S

So, Income effect = Total effect - Substitution effect = (R to T) - (R to S)

= S to T

(5) Decreased

Consumption decreased from 7 to 5, by 2 units.

(6) Normal good

Income effect is negative when the good is normal. Since we have a decrease in consumption signifying a negative income effect, the good is normal.

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