6RQ The price of cheese rises from \... [FREE SOLUTION]

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Chapter 6: 6RQ (page 133)

The price of cheese rises from $6 to $10 per pound, while the price of wine remains $3 per glass. For a consumer with a constant income of $3,000, show what happens to consumption of wine and cheese. Decompose the change into income and substitution effects.

Short Answer

Expert verified

The effect of increase in cheese price is shown below:

Point A to C movement shows the substitution effect.

Point C to B movement shows the income effect.

Step by step solution

Income effect and substitution effect

The income effect shows the change in consumption due to change in the real income, i.e., purchasing power. The substitution effect shows the change in consumption from high price goods to low price goods.

Decomposition of substitution effect and income effect

The price of cheese rises from $6 to $10; the budget line will shift inward. The new budget line will be BC₂ as shown in the diagram below:

The initial consumption bundle was at point A; after the shift of the budget line, the new consumption bundle will be at point B. To get the income and substitution effect, a parallel budget line to BC₂is drawn which is BC₃. The BC₃budget line is tangent to the initial indifference curve at point C.

The movement from point A to point C is the substitution effect; more wine is consumed after the rise in the price of the cheese. The movement from point C to B shows how a rise in cheese price reduces the real income of the consumer; declining the consumption, thus, declining the income effect.