Question

5. Consider two consumers, Jonathan and Caitlin, and Bob.   As on the first exam, each consumer likes to drink martinis.   Each consumer has very specific preferences, as stated below.

• Jonathan likes his martinis with 2 parts gin to 1 part vermouth and likes no other combination.
• Caitlin doesn’t care whether she has gin or vermouth; she just likes something to drink.  But gin is twice as potent as vermouth (has twice as much alcohol), so she is always willing to substitute 1 gin for 2 vermouth.

Assume that each consumer has a weekly budget of $30, the price of gin is $1 and the price of vermouth is $1.  

1. On the graphs below, draw a representative set of indifference curves for each consumer.  Indicate the current utility-maximizing point for each consumer, and label everything carefully, including slopes.  (30)

Put gin on the horizontal axis.

b. Now suppose that the price of gin increases to $2.  Carefully explain (with use of graphs AND WORDS) the income and substitution effects for each consumer.  (25)  (You should have income and substitution effects shown on the graphs above, and then you should explain them below.)

For Jonathan:

For Caitlin:

Answer 1

Given,

the prferences of Jonathan and Caitlin.

The budget that is 30.

The price of gin 1 and price of vermouth 1.

a) utility maximising point for on would be 20 parts gin and 10 parts vermouth. That would amount to 10 drinks.

This is derived by creating and indifference curve for on which would be straight line as the slope for MRS is always constant. The line of IC is equal to 2y=x.

For Jonathan there are a set utility curves formed by creating the given conditions. the slope of the curve would decline naturally as we move from rleft to right. considering that caitlin would drink anything and would only subtitute gin for two parts of vermouth. the Max utilising point would be ANY POINT on the budget line.

the diagrams for the same are illustrated below.

B) If the price of gin is increased to 2 dollars and keeping everything else same.

Income effect comes into play for Jonathan as now that his budget is constant and hence his income is constant but the price for gin has increased so the max utilising point shifts downwards. Jon can now just have 6 drinks instead of the prior 10 drinks he could have.

Substituition effect comes into play when the utility of two objects is same as in the case of caitlin so in this scenrio she will have more amouth of vermouth than gin as the prices of gin have risen and vermouth stayed the same hence for example if in first scenario if caitlin would have have equal amounts of both drinks whish is (12,18) now she would shift to the bundle (15,7.5).

Graphs are given below to explain the same