Tom devotes 30 to goods 1 and 2 and views them as perfect substitutes. In particular, Tom is always indifferent between 5 units of good 1 and 3 units…
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Tom devotes £30 to goods 1 and 2 and views them as perfect substitutes. In particular, Tom is always indifferent between 5 units of good 1 and 3 units of good 2. The initial prices are p01 = 5 and p02 = 6.
(a) Write down a utility function that captures Tom’s preferences.
(b) Suppose the price of good 2 increases to p12 = 7. Calculate the total effect of the price change on Tom’s consumption of good 2 and decompose this into the income and substitution effects.
(c) Starting from the initial prices (p01,p02), now suppose the price of good 2 increases to p12 = 9. Calculate the total effect of the price change on Tom’s consumption of good 2 and decompose this into the income and Slutsky substitution effects.
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