Question

Ray spends his entire budget on bread and gasoline. His preferences are complete, transitive, monotonic and convex. For Ray, bread is an inferior good that follows the law of demand. Moreover, the cross-price elasticity of demand for gasoline with respect to the price of bread is positive. Suppose the price of bread decreases, all else constant. a. Create a chart that shows the direction of the income, substitution and total effects on bread and gasoline. (10 points) b. What can you say, if anything, about the relative magnitudes of the income and substitution effects of the price decrease on the consumption of bread and gasoline? (5 points) c. Graphically decompose the total effect of the price decrease into the substitution and income effects on a well-annotated graph. Make sure you clearly label each of the 3 effects. (10 points)

Answer 1