Answer to Question #91691 in Microeconomics for John Manda

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

Income effect. Let's asume a consumer spends 10% of his/her income ($3,000) for buying cheese. So, at the price is $6 per pound he/she is able to buy 50 pounds of cheese. When the price goes up to $10, the consumer can afford to buy less cheese - only 30 pounds. With the same budget the person becomes poorer. The real income of that consumer falls. That is why when price rises the quantity demanded will fall, and vice versa.

Substitution effect. When the price of a certain product (cheese) rises this product becomes less attractive for a consumer, and the other product (for example, wine, which also satisfies consumer's needs) becomes more attractive. So, the consumer's basket will be changed in favor of cheaper products. The quantity demanded of the product which becomes more expencive will fall, and vice versa.