Currently, Paula is maximizing utility by purchasing 5 TV dinners (T) and 4 Lean Cuisine meals (L) each week.Graph Paula’s initial utility-maximizing choice.Suppose that the price of T rises by $1 and the price of L falls by $1.25. Can Paula still affordto buy her initial consumption choices? What do you know about her new budget constraint?Use your graph to show why Paula will choose to consume more L and less T given her new budget constraint. How do you know that her utility will increase?Some economists define the ‘‘substitution effect’’ of a price change to be the kind of change shown in part c. That is, the effect represents the change in consumption when the budget constraint rotates about the initial consumption bundle. Precisely how does this notion of a substitution effect differ from the one defined in the text?If the substitution effect were defined as in parts, how would you define ‘‘the income effect’’ to get a complete analysis of how a person responds to a price change?

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ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Currently, Paula is maximizing utility by purchasing 5 TV dinners (T) and 4 Lean Cuisine meals (L) each week.

Graph Paula’s initial utility-maximizing choice.
Suppose that the price of T rises by $1 and the price of L falls by $1.25. Can Paula still afford

to buy her initial consumption choices? What do you know about her new budget constraint?

Use your graph to show why Paula will choose to consume more L and less T given her new budget constraint. How do you know that her utility will increase?
Some economists define the ‘‘substitution effect’’ of a price change to be the kind of change shown in part c. That is, the effect represents the change in consumption when the budget constraint rotates about the initial consumption bundle. Precisely how does this notion of a substitution effect differ from the one defined in the text?
If the substitution effect were defined as in parts, how would you define ‘‘the income effect’’ to get a complete analysis of how a person responds to a price change?

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