Question

Suppose two goods, bread and cheese, provide a consumer with utility but only if they are consumed in fixed proportions. What will an increase in the price of bread yield in terms of substitution and income effects, in other words, explain if either effect will occur and what direction they will be in (different or similar direction).?

Answer 1

When two goods are used in a fixed proportion together they are considered perfect complements. There is no substitution effect defined for them for any price change simply because the two goods are not to be substituted against each other. Generally when two goods have a certain degree of substitution, a price rise for one of them encourages the consumption of the other.

In this case, since the goods are not substitutable against each other, a price rise in one of them has no substitution effect on the consumption of the other. However, since the real income has fallen now, the income effect would encourage the consumer to reduce the consumption of both goods. Hence the total price effect is only the income effect and is generally positive for normal goods (a price rise reduces income so consumption is reduced)