Question

Larry is at the local grocery store, shopping for himself and his friends, Moe and Curly. This week, ground hamburger is on sale for 35 percent off the regular price. How does the sale impact his budget constraint compared to all other goods? Explain the two effects Larry faces that may cause him to purchase more ground hamburger this week than he did last week?

Answer 1

Answer: Now the initial budget line for ground hamburger is AB and the initial budget line is tangent to the initial indifference curve IC1 at point M and the initial quantity of hamburger(x1) is q1. Now due to 35 percent off, price of hamburger falls and the budget line rotates outward from AB to AC and the new budget line is tangent to indifference curve IC2 at point N and the new quantity of hamburger is q3. Now the total increase in the quantity of hamburger from q1 to q3 is the total effect. Now the total effect of this discount is divided into a substitution effect and an income effect.

To understand the substitution effect, we hold the real income of the consumer constant. As a result of which, the consumer will stay on the same indifference curve but as the price ratio has changed due to a fall in the price of hamburger, hence consumer will stay on the budget line with the slope of the new budget line AC. Hence we draw a hypothetical budget line DE which is tangent to initial indifference curve IC1 at point O and parallel to the final budget line AC. Hence the movement from point M to point O or the increase in the quantity demanded of hamburger from q1 to q2 is due to the substitution effect.

Now to understand the income effect we consider real income as variable. Now as price of hamburger falls, there will be a parallel rightward shift of the budget line from DE to AC and the new budget line will be tangent to indifference curve IC2 at point N and the movement from point O to N I.e increase in quantity demanded of hamburger from q2 to q3 is the income effect.