Question

For each of the following cases, (1) graph the budget constraint and at LEAST 2 indifference curves (2) indicate the utility maximizing point (and the indifference curve that corresponds with that point) (3) SHOW and briefly explain what you would expect to happen if the price of the good changed as indicated, in terms of income and substitution effects. (Show income and substitution effects on your graph too) In all cases, assume that your intital income is $50 and that the price of each good is $2.

A) Coke and Pepsi are perfect substitutes for me, but I like Coke twice as much as Pepsi.

(Put Coke on the horizontal axis, and assume that the price of Coke rises to $5.)

B) I like my sandwiches to have exactly three slices of ham and two slices of cheese, and I don't like any other combination.

(Put ham on the horizontal axis, and assume that the price of ham falls to $1.)

C) The choice of vegetables is broccoli and carrots. I like broccoli, but I'm indifferent about carrots; I neither like nor dislike them.

(Put carrots on the horizontal axis, and assume that the price of carrots falls to $1.)

D) The choice of vegetables is broccoli and eggplant. I like broccoli, but I hate eggplant. Assume that you have to eat any vegetables that you actually have.

(Put eggplant on the horizontal axis, and assume that the price of eggplant falls to $1.)

Answer 1

Ans.

Income effect

When the price of a commodity falls, the real income of the consumer, that is his purchasing power increases. As a result he can now buy more of a commodity. This is called income effect. This causes increase in the quantity demanded of the good whose price falls.

Substitution Effect

When the price of a commodity falls, it becomes relatively cheaper than other good. This induces the consumer to substitute the relatively cheaper commodity for the other good which is relatively expensive. This is called the substitution effect. This causes increase in the quantity demanded of the commodity whose price has fallen.

Indifference Curve : An Indifference Curve is a graphical representation of all possible combinations of two goods which gives same level of satisfaction.    

Consumers equilibrium is defined as the level of consumption where the consumer derives maximum satisfaction from the consumption of commodities and does not have any desire to change from that level of consumption.

From the above diagram, it is clear that the consumer's optimal choice is at 'E' where he can buy OX level of commodity X and OY level of commodity Y. In this point, Budget line is tangent to the indifference curve. This is the maximum possible combination the consumer can attain according to his budget.

Eg. A) The demand for a commodity and the price of its substitutes goods are directly related to each other. When the price of Coke increases, the demand for Pepsi increases because pepsi can be substituted for coke.

Income of the consumer = $50

Price of Coke = $2.

Price of Pepsi = $2

When the consumer spent his entire income on Coke he can buy 25 units (bottles) of coke.

If he spends his entire income on Pepsi he can buy 25 units of Pepsi.

  When there is rise in price of Coke from $2 to  $5, the consumer is willing to buy more of Pepsi and less of Coke. As a result there is a change in Budget line and Indifference curve.

From the above diagram, it is clear that, when the Price of Coke increases, quantity demanded for Coke decreases. At the present price  $5 consumer can buy only 10 units of Coke, if he spends his entire income $50 on Coke.

Eg.B) Consumer is willing to have 3 slices of ham and 2 slices of Cheese at $2 each.When the price of ham per unit decreases fro $2 to $1, the consumer can buy more of ham. which shows that the demand for ham increases, as a result of fall in price.

Below diagram shows the budget line and indifference curve of ham and cheese and the qauntity demanded at price $2 each. Below that the demand curve of ham is shown. Its shows the income effect of the consumer. His purchasing power increases as a fall in price of ham. As a result the quantity demanded of ham increases.