Answer to Question #255603 in Microeconomics for Saman Khalil

Question

Currently, Paula is maximizing utility by purchasing 5 TV dinners (T) and 4 Lean Cuisine meals (L) each week.

Graph Paula’s initial utility-maximizing choice.

Suppose that the price of T rises by $1 and the price of L falls by $1.25. Can Paula still afford

to buy her initial consumption choices? What do you know about her new budget constraint?

Use your graph to show why Paula will chooseto consume more L and less T given her new budget constraint. How do you know that her utility will increase?

Some economists define the ‘‘substitution effect’’ of a price change to be the kind of change shown in part c. That is, the effect represents the change in consumption when the budget constraint rotates about the initial consumption bundle. Precisely how does this notion of a substitution effect differ from the one defined in the text?

If the substitution effect were defined as in partd, how would you define ‘‘the income effect’’ in order to get a complete analysis of how a person responds to a price change?

Answer 1

a. At point A utility is maximizing when T=4 and L=4 .

b. Budget constraint will be similar because net effect of these changes is decrease of $0.25.So due to this changes consumption of T will be decline and consumption of L will increase because the Paul is indifferent on any consumption in the curve.

c. Point b is new consumption point due to these changes and consumption of L increased and consumption of T decline. Utility will be similar because in indifference curve which touches budget line have maximum utility.

d. The substitution effect discussed in the text speaks about change in the price of only one good keeping the income and price of all other goods unchanged. Hence, the y -axis intercept remains unchanged and x -axis intercept moves right or left depending upon whether there is fall or rise in price. The budget constraint move along the y -intercept.

The substitution effect, however, in this problem involve change in the prices of both the goods. This rotates the budget constraint about the previous consumption bundle.

e. Since rise in the price of T is less than the fall in the price of L, Paula’s real income has increased. The income effect, therefore, will shift the budget line shifts outward parallel to A'B'. This implies that Paula is able to afford a larger set of bundles than before, leading her to a higher utility level.

The total effect of change in the prices of T and L is the movement from point E to E''.