Income and substitution effects. Eric and Ginny Gaffney live in dallas and enjoy
ID: 1225355 • Letter: I
Question
Income and substitution effects.
Eric and Ginny Gaffney live in dallas and enjoy going out to fanct restuarants for diners for breakfast.
Do No Harm: 3 9. Income and substitution effects Eric and Gintty Gaffney live in Dallas and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves 1 and 2 represent two of their indifference curves ror fancy dinners and diner breakfasts. They have $500 per month available to spend on eating out. The price of a diner breakfast is always $5. Each labeled point represents the tangency between a budget constraint and the 67 60 50 5 7 a FANCY DINNERS The initial budget constraint BCI shows the Gartneys budget constraint when the price of a fancy dinner is $25. At this price, Eric and Ginny would choose to consume eight fancy dinners. Suppose that the price of a fancy dinner increases to 50, shifting their budget constraint to 2, which represents a new relative price of ten diner breakfasts per fancy dinner. (Hint: The blue line labeled H is parallel to BC2 and tangent to at point Y.) In order to remain as happy as they were before the price increase-that is, to consume at some point on the same indifference curve as they were on initially (h)-the Gaffneys income spent on fancy dinners and breakfast at diners would now have to be $60. However, in reality, rather than maintaining their original level of utility, the Gaffneys choose the optimal bundle along their new budget constraint. At this point, they are worse off than before the price dange in fancy dinners. On the folowing table, indicate which point movement represents the substitution effect and income effect for farncy dinners when Dhe price increases rom $25 to $50. Then indicate if each effect is positive or negative in this case. Consumption Change (Quantity of fancy dinners) Fancy Dinners Substitution Effect Income Effect Represented By... Positive or Negative In this case, the price increase of fancy dinners causes the Gattneys's real income to income and the direction of the income effect, fancy dinners are Because of the change to Eric and Ginny's real for the Gaffneys. Grade t Now Save & Continue Cannue without savingExplanation / Answer
(a) Keeping satisfaction the same, another point on IC1 is point Y (67 diner breakfasts & 7 fancy dinners),
Total income = 67 x $5 + 7 x $50 = $(335 + 350) = $685
In reality, they choose at point Z where they are WORSE OFF (since they lie on a lower indifference curve).
(b) Substitution effect: X to Y. They consume 1 less (= 8 - 7) fancy dinners. It is Negative.
(c) Income effect: Y to Z. They consume 2 less (= 7 - 5) fancy dinners. It is Negative.
(d) Price decrease causes real income to decrease. Fancy dinners are a normal good.