Question

The price of cheese rises from $6 to $10 per pound,while the price of wine
remains $3 per glass.For a consumer with a constant income of $3,000,show
what happens to consumption of wine and cheese.Decompose the change into
income and substitution effects

Answer 1

Answer to Question #91067, Economics / Microeconomics

A rise in price of cheese makes the x-intercept shift from 500 to 300. Consumers budget constraint also moves from BC1 to BC2 and optimal mix moves from A to B. To divide the change into income and substitution effect a new budget line BC3 parallel to BC2 and tangent to first indifference curve at C is drawn. A shift from A to C is the substitution effect while C to B is the income effect. Since cheese becomes relatively expensive the buyer substitutes wine for cheese as he moves from A to C (substitution effect). An increase in price of cheese causes a corresponding decrease in income from C to B

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