Please note, this is all of the information listed in the question. I would assu
ID: 1167311 • Letter: P
Question
Please note, this is all of the information listed in the question. I would assume the blue L1 is the original budget line, and e1 is the original equilibrium. I also assume I1, I2, and I3 are the 3 different income scenarios.
Discuss the substitution, income, and total effects of a price change for Coke for Mary, who views Coke and Pepsi as perfect substitutes.
Assume for simplicity that the price of a can of Coke increases such that it becomes twice that of a can of Pepsi.
The size of the substitution effect (in terms of Coke) is _____ cans, the income effect is ______ cans, and the total effect is ______ cans.
2 ke 15- 14 13- 12 10- he as 7 1 2 e1 0 1 2 3 45678 9 10 11 12 13 14 15 Coke, Cans per weekExplanation / Answer
Consider the given problem here there are two goods, “cans of Coke” and “cans of Pepsi”. Now, the utility function is “perfect substitute”, => a typical consumer will prefer the cheapest one. So, here the “blue line” is the actual budget line having horizontal and vertical intercept “12” and “8” respectively, => if the consumer spend the total income on only “Coke”, => the person will be able purchase “12 cans of coke”. Similarly, if the consumer spends the total income on only “Pepsi”, => the person will be able purchase only “8 cans of Pepsi”. So, given the preference the consumer will find it optimum to spend totally on “Pepsi”.
Now, if the price of “Coke” increases to twice of “Pepsi”, => given the income the horizontal intercept decreases to “4”, => “Pepsi” will be the cheapest good here, => given the utility function the consumer will prefer to spend totally on “Pepsi” and not on “Coke”.
So, here the “total effect” is “-12”, in terms of “Coke”. Now, we can decompose it into “substitution effect” and “income effect”. So, here as the goods are substitute to each other, => as “Pepsi” become relatively cheaper compare to “Coke”, => the consumer totally shift to “Pepsi” from “Coke”, => there is only “SE” and no “IE”.
So, here “TE = SE = (-12)” and “IE = 0”.