Consider the following three graphs, which illustrate the preferences of three consumers (Bob,...

Question

Consider the following three graphs, which illustrate the preferences of three consumers (Bob, Carol, and Ted) regarding two goods, apples and peaches. Each consumer has an income of $30, and each consumer pays $2 for apples and $3 for peaches.

a. Suppose that the price of peaches falls to $2. Draw a new budget line for each consumer and find the new optimal bundle of apples and peaches each would buy. How does the new quantity of peaches compare to the original quantity? Indicate the change in the first column of the table below (an increase of one unit might be denoted as a +1).

b. For each consumer, determine the substitution effect of the price change by drawing a hypothetical budget line with the same slope as your new budget line, but just tangent to the consumer’s original indifference curve. How much of a change in peach consumption does the substitution effect account for? Indicate that change in the first column of the table below.

c. Now add in the income effect. Compare each consumer’s peach consumption in (b) to his or her final peach consumption in (a). Indicate the difference in column 3 of the table below. Double-check your work to ensure that the last two columns add up to the number in the first column.

d. Do Bob, Carol, and Ted consider peaches normal, inferior, or income-inelastic?

Robert · Accepted Answer

Let M denote the income of each consumer, PA and PP denote the prices of apples and peaches 
respectively. 
Thus to satisfy the budget constraint we must have: M = APA + PPP where A and P denotes 
apples and peaches respectively. 
Let us start with Bob.
Bob is initially at point A on U1. BB is the initial budget line. At point A Bob purchases 5 peaches 
at PP= 3. Thus at PA = 2, Bob purchases we have 30 = 2A + (3 x 5) => 30 = 2A + 15 
Thus at point A, Bob buys 7.5 apples at PA = 2. 
Now as price of peaches fall to 2, the budget line rotates outwards and becomes flatter. Thus the 
new budget line for Bob is BB'. At BB' U2 is tangent at point B. Here the utility increases as the 
purchasing power of Bob rises due to the fall in price of peaches. 
The movement from A to B shows the total effect due to the fall in PP. At point B with PP = 2, Bob 
buys 9 peaches. Thus we have: 
30 = 2A + (9 x 2) 
=> 30 = 2A + 18 
=> A = 6. 
Thus as the price of peaches fall, the total price effect denoted by a movement from A to B where 
the number of peaches bought rises from 5 to 9 and the number of apples bought falls from 7.5 
to 6. Now to keep utility fixed at U1, we draw a budget line parallel to BB' and tangent to U1 at 
point D. At point D amount of peaches purchased is 6.

Consider the following three graphs, which illustrate the preferences of three consumers (Bob, Carol, and Ted) regarding two goods, apples and peaches. Each consumer has an income of $30, and each...

Solution

Answer To This Question Is Available To Download

Related Questions & Answers

Submit New Assignment