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Quiz 8. Demand Effects Ans

# Quiz 8. Demand Effects Ans - Shomu Banerjee ECON 201 INCOME...

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Shomu Banerjee ECON 201 INCOME, SUBSTITUTION & PRICE EFFECTS ANSWERS 1. Joan's monthly income is \$120, p y = \$20/bottle, p x is \$12/pie. Her preferences for pies and champagne can be represented by the following utility function: u ( x , y ) = x + y . (a) Draw Joan’s initial budget constraint and show where on this budget constraint she will maximize her utility. Joan’s initial budget constraint is drawn in blue. The utility maximizing point is at A. (b) Now p x falls to \$6/pie. Draw Joan’s new budget constraint and show where on this budget constraint she will maximize her utility. The new budget constraint is shown with the red solid line. The utility maximizing point is at C. (c) Show the price, income and substitution effects. ‘Pull’ the red budget line back until it barely touches the old indifference curve with utility level u o . This happens at point A. Label this point B. The substitution effect is the movement from A to B; because B coincides with A, it is zero. The income effect is the movement from B to C which is the same as the price effect.

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