Question

Hannah always consumes pizza with a bottle of pepsi. Her monthly demand function for pizza is given as X=M/P1+P2, where M is her monthly income, P1 and P2 are prices of pizza and pepsi respectively. Her original income is $80, price of pizza is $7 and price of pepsi is $1. If the price of pizza falls to $5: How much do we take away from Hannah for her to be able to afford her old bundle? What is the income and substitution effect of the price change?

Answer 1

Answer : Given,

Monthly demand: X = M/P1 + P2 ; M = $80; P1 = $7;

P2 = $1

By putting all values in demand function, we get,

X = 80/7 + 1 = 11.43 + 1 = 12.43

Now P1 becomes $5. New demand becomes,

X = 80/5 + 1 = 16 + 1 = 17

Therefore, as price of pizza decrease, the demand for pizza increase than before. The difference between new consumption bundle and old consumption bundle is ( 17 - 12.43 ) = 4.57

This shows that consumption increased by 4.57 after decreasing price of pizza.

As price level of pizza decreases, the income level increases and because of this relative price change consumption of pizza increases. Here the increased income level is income effect and changed relative price is substitution effect. Therefore , the income and substitution effect is 4.57 . Because here income effect = substitution effect. This means the amount of increased income after pizza price decrease is spent on more pizza consumption.