Question

Leah divides her income between lemons and bottles of seltzer water (both of which are normal goods.) An early frost causes a large increase in the price of lemons.

16.1.

A) Compared to before the frost, this means that if she spends all of her money on lemons, Leah can buy ________, and if she spends all of her money on seltzer water, Leah can buy ________.

A.  The same number of lemons; fewer bottles of seltzer water. B.  Fewer lemons; more bottles of seltzer water. C.  The same number of lemons; the same number of bottles of seltzer water. D.  Fewer lemons; fewer bottles of seltzer water. E.  Fewer lemons; the same number of bottles of seltzer water.

B) After figuring out her new optimal bundle of lemons and bottles of seltzer water, Leah chooses to consume fewer bottles of seltzer water. This means that the __________ effect dominated the __________ effect.

A.  Income; substitution B.  Substitution; income

Answer 1

For A), the answer is E. Leah can buy fewer lemons and the same number of bottles of seltzer water.

This is because the price of seltzer water has not changed. Therefore, if she spends all her money on Seltzer water, she would be able to buy the same number of bottles when the price of lemons has increased. On the other hand, if she spends everything on lemons, she will have fewer lemons.

For B), the answer is A. The income effect dominated the substitution effect.

The income effect says that when the price of a good increases, your purchasing power falls and that leads to a reduction in consumption levels of all goods. The substitution effect says that when the price of a good increases, consumers shift demand to the other goods and therefore, the demand for other goods increase. Here, we are told that the net demand for water goes down with the increase in the price of lemons. Therefore, the income effect which leads to a fall in demand for water dominates the substitution effect which suggests an increase in the demand for water.