Question

A cup of Starbucks coffee is just as good as a cup of Dunkin Donuts coffee for me (assuming equal-sized cups.) The price of coffee at Starbucks used to be $1.50 compared to $1 at Dunkin Donuts. Because of the Pandemic, Dunkin Donuts lower the price of this size cup of coffee to $0.90.

1. What will happen to my new utility compare to my utility before, after this price decrease? Carefully explain
2. With my income, m, what is my demand function for Starbucks? What about Dunkin Donuts?
3. What is the substitution effect from this price changed? Carefully explain your answer

Answer 1

A) Because both companies coffee is same for CONSUMERs ,so it means both are perfect substitues for him.so before price Decrease,price of coffee at Starbucks is higher but giving same utility,so CONSUMER would have been buying all coffee from Dunkin donuts.

After price Decrease,he still buying all coffee from Dunkin donuts, but lower price increase number of coffee he can buy now with same income ,so his utility will increase.

B) Demand function of Starbucks:Q=0,if Ps>Pd

And Q=M/Ps, if Ps≤Pd

So current demand of Starbucks=0

Same for demand function of Dunkin donuts:Q=0, If Ps<Pd and Q=M/Pd, if Ps≥Pd

C) Substitution effect is zero. Because CONSUMERs didn't change its composition of goods ,only Increase the amount of Dunkin donuts coffee,which he was already consuming initially.