Question

Akbar one of FEB UI students have options for lunch: eat at the canteen (K) for IDR 90,000 / portion or eat at the warteg (W) IDR 22,500 / portion. Akbar's parents provide an allowance of Rp 900,000 per month for the lunch budget.

a. Draw the budget constraint equation for Akbar. Assume that Akbar allocates equal portions of K and W. Describe the optimum equilibrium situation. Label A on the optimum choice!

b. For example, the price at warteg rises to IDR 30,000 / portion. Show the impact of these price changes on a chart. Assume that Akbar now allocates only 30% of his budget to K. Label B the optimum balance.

c. What happens to the quantity (Q) due to the change in price. Show the substitution and income effect. Explain briefly.

d. Derivate the demand curve W. What kind of good is W?

Answer 1

P_k = 90,000

P_w = 22,500

Income =900,000 per month

If Akbar spends all his money on K, he can afford . (900,000/90,000 = 10 units.) But if he does this, he won’t be able to afford any W. This choice (zero W) is shown by point B in the figure. Alternatively, if Akbar spends all his money on W, he can afford (900,000/22500. =40units per month.) Then, however, he will not be able to afford any K. This alternative choice (40 W and zero K ) is shown by point F. The slope of the budget constraint is determined by the relative price of K and W.

If Akbar is like most people, he will choose some combination that includes both K and W—that is, he will choose one of the points along the budget-constraint line that connects points G and F. Each point inside or on the budget constraint shows a combination of K and W that he can afford. (G point inside the curve is definitely an option—it just means that he isn’t spending all his money.) Keep in mind that the curve represents the maximum number of K and W he can buy. Any point outside the constraint is not affordable, because it would cost more money than Akbar has in his budget.

The budget constraint clearly shows the trade-off Charlie faces in choosing between K and W.

K	W	BUDGET ALLOCATION
10	0	10*90,000+ 0*22500 = 9000,000
9	4	9*90,000 + 4*22500 = 900,000
8	8	8*90,000 + 8*22500= 900,000
7	12	7*90,000 + 12*22500= 900,000
6	16	6*90000 + 16*22500 = 900,000
5	20	5*90000 + 20*22500 = 900000
4	24	4*90000 + 24* 22500 = 900000
3	28	3*90,000 + 28*22500 =900,000
2	32	2*90,000 + 32*22500= 900,000
1	36	1*90,000 + 36*22500= 900,000
0	40	0*90,000 + 40*22500= 900,000

AS he is allocation equal portions so his optimum equillibrium will 8 units of K and 8 units of W.

c) Due to change in price the quantity decreases for both the goods.

The substitution effect is that when a good becomes more expensive, people seek out substitutes.The income effect refers to how a change in the price of a good alters the effective buying power of one’s income.

The original choice is A, but due to change in price the new equillibrium becomes B . The substitution effect is from point A to C in the graph which is getting fewer K and more W. The income effect is from C to B that is reduction in buying power of Akbar.

part D

K is a normal good as the price ries its demand decreases.

W is a giffen good as the demand increases even if though the price rises . The demand curve will be upward sloping.