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Magazine Chapter 6: 1PA (page 133)
Maya divides her income between coffee and croissants (both of which are normal goods). An early frost in Brazil causes a large increase in the price of coffee in the United States.
a. Show the effect of the frost on Maya鈥檚 budget constraint.
b. Show the effect of the frost on Maya鈥檚 optimal consumption bundle, assuming that the substitution effect outweighs the income effect for croissants.
c. Show the effect of the frost on Maya鈥檚 optimal consumption bundle, assuming that the income effect outweighs the substitution effect for croissants.
Short Answer
a. The rise in the price of coffee will result in the budget shift inward. The budget line moves from AB to AC.
b. If the substitution effect outweighs the income effect, the consumption of coffee will fall, and the consumption of croissants will increase.
c. If the income effect outweighs the substitution effect, the consumption of coffee will fall, and the consumption of croissants will fall.
Step by step solution
Substitution effect and income effect
The fall in consumption of one product is due to the rise in its price. The substitution effect captures the increase in consumption of another due to a rise in the price of the former. The increase in the product's price leading to a fall in the real income of an individual is captured by the income effect.
Explanation of part (a)
The initial budget line will be AB. After the rise in the price of coffee, the budget line will shift inwardto AC.
The croissants鈥� intercept, that is, point A, will not change as the price of croissants and the consumer's income level is unchanged.
Explanation of part (b)
The substitution effect outweighs the income effect, i.e., the cheaper good consumption will increase, and the costly good consumption will fall.
The initial consumption point is at point E. After the rise in the price of coffee, the budget line shifts inward to AC, and a parallel line is drawn to AC, which is tangent to the initial IC. The movement from point E to F is the substitution effect, and from point E to D is the income effect. The summation of the income effect and the substitution effect will be the price effect. The price effect will be from point E to D.
Explanation of part (c)
The income effect outweighs the substitution effect, i.e., the consumption of cheaper goods and costly goods will fall.
The initial consumption point is at point E. After the rise in the price of coffee, the budget line shifts inward to AC, and a parallel line is drawn to AC, which is tangent to the initial IC. The movement from point E to F is the substitution effect, and from point E to D is the income effect. The summation of the income effect and the substitution effect will be the price effect. The price effect will be from point E to D.
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