Question

Mr. Consumer allows himself to spend $100 per month on cigarettes and ice cream. Mr. C’s preferences for cigarettes and ice cream are unaffected by the season of the year.

(1) In January, the price of cigarettes was $1 per pack, while ice cream cost $2 per pint. Faced with these prices, Mr. C bought 30 pints of ice cream and 40 packs of cigarettes. Draw Mr. C’s January budget line and label his January consumption bundle with the letter J. Label the line clearly.

(2) In February, Mr. C again had $100 to spend and ice cream still cost $2 per pint, but the price of cigarettes rose to $1.25 per pack. Mr. C consumed 30 pints of ice cream and 32 packs of cigarettes. Draw Mr. C’s February budget line, labelling it clearly, and mark his February bundle with the letter F (You can use the same graph). How does the substitution effect of this price change change his consumption of cigarettes and ice-cream (just give the direction of change - more, less or the same)? Given this, and that the total change in his ice cream consumption is zero, what can you say about the income effect of the price change on his consumption of ice cream? Does it make him buy more ice cream or less? Is the income effect of the price change like the effect of an increase in his income, or a decrease? Do these answers suggest that ice cream is a normal good, or an inferior, or a neutral good?

(3) In March, Mr. C again had $100 to spend. Ice cream was on sale for $1 per pint. Cigarette prices, meanwhile, increased to $1.50 per pack. Draw his March budget line on the same graph, labelling it clearly. Is he better off than in January, worse off or can you not make such a comparison? How does your answer to the last question change if the price of cigarettes had increased to $2 per pack?

Answer 1

2. the substitution effect of this price change change his consumption of cigarettes and ice-cream , he buys less cigarettes and more ice cream.

Since this is true and the total change in his ice cream consumption was zero, it must be that the income

effect of this price change on his consumption of ice cream makes him buy less ice cream. The income

effect of this price change is like the effect of an decrease in his income, which means ice cream is a normal good.

3.In January he is better off, however it we can't tell for the second question.