The initial budget constraint (BC1) shows the Gaffneys' 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 BC2, which represents a new relative price of ten diner breakfasts per fancy dinner. (Hint: The blue line labeledH is parallel to BC2 and tangent to I 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 (I)-the Gaffneys' income spent on fancy dinners and breakfast at diners would now have to be $ 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 off than before the price change in fancy dinners. On the following table, indicate which point movement represents the substitution effect and income effect for fancy dinners when the price increases from $25 to $50. Then indicate the consumption change that results from each effect. Consumption Change Fancy Dinners Represented By... (Quantity of fancy dinners) Substitution Effect Income Effect Because of the change to Eric and Ginny's real In this case, the price increase of fancy dinners causes the Gaffneys's real income to for the Gaffneys. income and the direction of the income effect, fancy dinners are
The initial budget constraint (BC1) shows the Gaffneys' 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 BC2, which represents a new relative price of ten diner breakfasts per fancy dinner. (Hint: The blue line labeledH is parallel to BC2 and tangent to I 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 (I)-the Gaffneys' income spent on fancy dinners and breakfast at diners would now have to be $ 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 off than before the price change in fancy dinners. On the following table, indicate which point movement represents the substitution effect and income effect for fancy dinners when the price increases from $25 to $50. Then indicate the consumption change that results from each effect. Consumption Change Fancy Dinners Represented By... (Quantity of fancy dinners) Substitution Effect Income Effect Because of the change to Eric and Ginny's real In this case, the price increase of fancy dinners causes the Gaffneys's real income to for the Gaffneys. income and the direction of the income effect, fancy dinners are
Chapter4: Utility Maximization And Choice
Section: Chapter Questions
Problem 4.4P
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Transcribed Image Text:The initial budget constraint (BC1) shows the Gaffneys' 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 BC2, 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 I1 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
. However, in reality, rather than
initially (I1)-the Gaffneys' income spent on fancy dinners and breakfast at diners would now have to be $
maintaining their original level of utility, the Gaffneys choose the optimal bundle along their new budget constraint. At this point, they are
off than before the price change in fancy dinners.
On the following table, indicate which point movement represents the substitution effect and income effect for fancy dinners when the price increases
from $25 to $50. Then indicate the consumption change that results from each effect.
Consumption Change
Fancy Dinners
Represented By...
(Quantity of fancy dinners)
Substitution Effect
Income Effect
Because of the change to Eric and Ginny's real
In this case, the price increase of fancy dinners causes the Gaffneys's real income to
for the Gaffneys.
income and the direction of the income effect, fancy dinners are
S
>
Transcribed Image Text:Attempts
Keep the Highest / 3
9. Income and substitution effects
Eric and Ginny 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 I1 and I2 represent two of their indifference curves for 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
corresponding indifference curve.
Y
67
60
50
1/2
BC,
H
BC,
0.
7 8
FANCY DINNERS
DINER BREAKFASTS
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