9. Income and substitution effects
Tim and Alyssa Galego live in Houston and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves I1 and I2 represent two of their indifference curves for fancy dinners and diner breakfasts. They have $400 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.
The initial budget constraint ( BC1 ) shows the Galegos’ budget constraint when the price of a fancy dinner is $25. At this price, Tim and Alyssa would choose to consume six fancy dinners.
Suppose that the price of a fancy dinner increases to $50, shifting their budget constraint to BC2 , which represents a new relative price of ten diner breakfasts per fancy dinner. (Hint: The blue line labeled H is parallel to BC2 and tangent to I1 at point S.)
In order to remain as happy as they were before the price increase—that is, to consume at some point on the same indifference curve as they were on initially ( I1 )—the Galegos’ income spent on fancy dinners and breakfast at diners would now have to be
. However, in reality, rather than maintaining their original level of utility, the Galegos choose the optimal bundle along their new budget constraint. At this point, they are off than before the price change in fancy dinners.
On the following table, indicate which point movement represents the substitution effect and income effect for fancy dinners when the price increases from $25 to $50. Then indicate the consumption change that results from each effect.
(Quantity of fancy dinners)
In this case, the price increase of fancy dinners causes the Galegos’s real income to . Because of the change to Tim and Alyssa’s real income and the direction of the income effect, fancy dinners are for the Galegos.
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