Question

Suppose you have a choice between traveling by car or by airplane for your summer vacations. Represent your choices graphically using indifference curve analysis, where the indifference curves satisfy all the mathematical properties of consumer preferences. (20 points)

(a) Draw a budget line with car rides measured on the X-axis and airplane rides measured on the Y-axis. Next, illustrate your consumer equilibrium point when you travel sometimes by air and sometimes by car. Label the optimal consumption bundle clearly.

(b) Graphically present a price decrease in airline travel in your model and the resulting equilibrium.

(c) Illustrate the new consumption bundle if your income doubled from the original equilibrium.

(d) Show the income and substitution effects if car rides are an inferior good to you.

Q4: How can savings (incomes not spent on consumption) be incorporated into the utility maximization model using marginal utility analysis?

Answer 1

A).

Consider the given problem here there are two goods “Airplane rides” and “Car rides”. Now, we have measured “Airplane rides” on the vertical axis and “Car rides” on the horizontal axis.

Now, the initial budget line is “D1D2” and “E1” be the equilibrium where the budget line is the tangent to the “U1”, => the optimum choice of the two goods are given by “C1” and “A1”.

B).

Now, let’s assume as the price of “airline travel” decreases the budget line become steeper given the horizontal intercept same.

So, the budget line shift from “D1D2” to “D3D2” and the new equilibrium is “E2” where the new budget line is tangent to “U2”. So, the new consumption bundle is given by “C2” and “A2”. So, the price of “Airline” decreases implied the consumption of “airline” increases and consumption of “Car rides” decreases.

c).

Now, consider the case where the income gets double.

  

So, the initial budget line is “D1F1” and the equilibrium is “E1”. Now, as the income get double the budget line shift to the right side to “D2F2”. So, the new equilibrium is “E2”. So, the new consumption bundle is “C2” and “A2”. So, as the income increases the consumption of both “car rides” and “airlines” increases.

d).

Now, assume that “car ride” is an inferior good and as the price of car ride decreases implied the budget line get flatter given the same vertical intercept. So, the new budget line is given by “D1F2”. So, here the consumption of “car ride” increases from “C1” to “C2”, => the movement from “C1 to C2” is the total effect of price change. Now, to decompose the “TE” in to “IE” and “SE” we have to deduct the income of the consumer such that the new budget line “D3F3” is tangent to the initial level of utility “U0”.

So, the new equilibrium is “E3” where “D3F3” is tangent to “U0”. So, the optimum consumption of “car ride” is “C3”. So, the movement from “C2” to “C3” is the IE. So, here “C1C2” is more than “C2C3”, => “SE > IE”. So, as the “car ride” is inferior good the SE is more than IE and both are in opposite direction.