Question

Consider Scott who consumes only two goods, Coke (Y) and Steak (X). The prices of Coke and steak are $2.00 and $10.00, respectively. He has a weekly budget of $90 and his optimal consumption bundle is 20 units of Coke and 5 units of steak per week. (20) (a) Draw Scott’s optimal choice diagram for Coke and steak. [Note: define the budget constraint, the slope, and the utility function.] (4) Scott found that the price of steak is reduced to $7.50. He now buys the same amount of steak (i.e., 5 units) and more Coke (i.e., 24 units). (b) Show the effect of the price change on steak in the graph (a). [Note: define the budget constraint, the slope, and the utility function.] (5.5) (c) Illustrate Scott’s purchasing behavior for steak and support your answer. [Note: discuss the substitution effect and the income effect.] (5) (d) Discuss Scott’s pattern of consumption for steak. Is there anything unique about his consumption behavior? Explain and support your answer

Answer 1

Price of coke(y) =$2.00

Price of steak(x)=$10.00

Budget of scott =$90

Utility function means the amont of satisfaction aconsumer gets from a particular bundle of goods or services.let u(x,y) represents the utility that aconsumer get from consuming x units of steak and y units of coke.

Budget constraints represents how many of goods on the y axis the consumer must give up in order to be able to afford one more of the good on the x axis.

slope represents the amount of goods2 given upto have one more unit of good1.

a)

b) as the decrease in the price of steak to $7.50 ,the demand for coke increass and demand for steak is same.

c) substitution effect considers the change in the relativeprice,with a sufficient change in income to keep the consumer on the same utility function.The substitution effect occurs when a price changes and consumers have an incentive to consume more good with relatively lower price and less of the good with relatively higher price.The income effect is that a lower price means,the buying power of income has been increased.(eventhough actual income has not changed),which leads to buying more of the good(when the good is normal).

In this example,the lower price for steak would cause scott to buy more coke.

when the price decreases,the budget constraint shift to right.the new choices would be more cke and same steak.the lower price of steak led to exactly the same units of steak used,but increased coke.The decrease for steak would have no effect on the ability to purchase coke,but it increased the number of coke scott could purchase.Thus a price decrease for steak causes the budget constraints to rotate outward .

d)Scott might react to a decrease price for steak by purchasing more steak ,but increasing his consumption of coke.this choice is the point on the new constraints,straight above the original choice.

the key is that it would be imprudent to assume that a change in the price of steak will affect the coke ,while the quantity consumed of steak remains same.since scott purchasesall his products out of the same budget a change in the price of steak.