Yakov and Ana Wong live in San Diego and enjoy going out to fancy restaurants fo
ID: 1123466 • Letter: Y
Question
Yakov and Ana Wong live in San Diego and enjoy going out to fancy restaurants for dinner and to diners for breakfast. On the following diagram, the purple curves I, and /2 represent two of their indifference curves for fancy dinners and diner breakfasts. They have $1,000 per month available to spend on eating out. The price of a diner breakfast is always $10. Each labeled point represents the tangency between a budget constraint and the corresponding indifference curve 70 50 BC BC 5 6 8 FANCY DINNERS The initial budget constraint (BC1) shows the Wongs' budget constraint when the price of a fancy dinner is $100. At this price, Yakov and Ana would choose to consume five fancy dinners Suppose that the price of a fancy dinner decreases to $50, shifting their budget constraint to BC2, which represents a new relative price of five diner breakfasts per fancy dinner. (Hint: The blue line labeled H is parallel to BC2 and tangent to 11 at point Y.) In order to remain as happy as they were before the price decrease-that is, to consume at some point on the same indifference curve as they were on initially (I)the Wongs' income spent on fancy dinners and breakfast at diners would now only have to be than maintaining their original level of utility, the Wongs choose the optimal bundle along their new budget constraint. At this point, they are However, in reality, rather off than before the price change in fancy dinnersExplanation / Answer
As a result of a fall in the price of fancy dinners, the budget line tilts frim BC1 to BC2. The new optimal, utility maximizing bundle is now Z with increased purchasing power as a result of a fall in the price. In order to remain as happy as they were before the price decrease - that is, to consume at some point on the old indifference curve I1, (where the prices have changed and the consumer has the same utility as they received before the price change, the increase in purchasing power is cut back to make the consumer as well off as before the price chnage).
Here they are able to consume bundle Y that is on the same IC i.e., I1. At Y, they consume 30 units of diner breakfasts and 8 fancy dinners.
The Wongs income spent on fancy dinners and breakfast at diners would now only have to be
(10 x 30) + (8 x 50) = $700.
However, in reality, the income is $1000 which is higher than that of $700 when the utility is held constant.
And, rather than maintaining the original level of utility, the Wongs choose the optimal bundle on their new budget constraint. This bundle is Z. The consumer is better off than before the price change in fancy dinners. Thus, he moves to higher indifference curve and to an optimal bundle Z due to an increase in utility.
Substitution effect is the movement from bundle X to Y, where the consumption of fancy dinners changes by +3 i.e., from 5 to 8. The substitution effect here, due to a decline in price, is positive.
The income effect is the movement from bundle Y to Z, where the consumption of fancy dinners changes by -2 i.e., from 8 to 6. The income effect here, due to a decline in price, is negative because when the utility increases, not all increase in utility is shifted to the consumption of fancy dinners. Some is utilized for breakfast at diners as well.
In this case, the price increase of fancy dinners causes the Wongs real income to increase . Because of the change to Yakov and Ana's real income and the 'direction of the income effect' (since it is negative), fancy dinners are Inferior good for the Wongs.
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