Check Your Understanding

1. Question

   In each of the following cases, state whether the income effect, the substitution effect, or both are significant. In which cases do they move in the same direction? In opposite directions? Why?

   1. Orange juice represents a small share of Clare’s spending. She buys more lemonade and less orange juice when the price of orange juice goes up. She does not change her spending on other goods.

      Since spending on orange juice is a small share of Clare’s spending, the income effect from a rise in the price of orange juice is insignificant. Only the substitution effect, represented by the substitution of lemonade for orange juice, is significant.

   2. Apartment rents have risen dramatically this year. Since rent absorbs a major part of her income, Delia moves to a smaller apartment. Assume that rental housing is a normal good.

      Since rent is a large share of Delia’s expenditures, the increase in rent generates an income effect, making Delia feel poorer. Since housing is a normal good for Delia, the income and substitution effects move in the same direction, leading her to reduce her consumption of housing by moving to a smaller apartment.

   3. The cost of a semester-long meal ticket at the student cafeteria rises, representing a significant increase in living costs. As a result, many students have less money to spend on weekend meals at restaurants and eat in the cafeteria instead. Assume that cafeteria meals are an inferior good.

      Since a meal ticket is a significant share of the students’ living costs, an increase in its price will generate an income effect. Students respond to the price increase by eating more often in the cafeteria. So, the substitution effect (which would induce them to eat in the cafeteria less often as they substitute restaurant meals in place of meals at the cafeteria) and the income effect (which would induce them to eat in the cafeteria more often because they are poorer) move in opposite directions. This happens because cafeteria meals are an inferior good. In fact, since the income effect outweighs the substitution effect (students eat in the cafeteria more as the price of meal tickets increases), cafeteria meals are a Giffen good.

2. Question

   The price of strawberries falls from $1.50 to $1.00 per carton, and the quantity demanded goes from 100,000 to 200,000 cartons. Use the midpoint method to find the price elasticity of demand.

   By the midpoint method, the percent change in the price of strawberries is Similarly, the percent change in the quantity of strawberries demanded is Dropping the minus sign, the price elasticity of demand using the midpoint method is 67%/40% = 1.7.

3. Question

   At the present level of consumption, 4,000 movie tickets, and at the current price, $5 per ticket, the price elasticity of demand for movie tickets is 1. Using the midpoint method, calculate the percentage by which the owners of movie theaters must reduce the price in order to sell 5,000 tickets.

   By the midpoint method, the percent change in the quantity of movie tickets demanded in going from 4,000 tickets to 5,000 tickets is Since the price elasticity of demand is 1 at the current consumption level, it will take a 22% reduction in the price of movie tickets to generate a 22% increase in quantity demanded.

4. Question

   The price elasticity of demand for ice cream sandwiches is 1.2 at the current price of $0.50 per sandwich and the current consumption level of 100,000 sandwiches. Calculate the change in the quantity demanded when price rises by $0.05. Use Equations 46-1 and 46-2 to calculate percent changes and Equation 46-3 to relate price elasticity of demand to the percent changes.

   Since price rises, we know that quantity demanded must fall. Given the current price of $0.50, a $0.05 increase in price represents a 10% change, using the method in Equation 46-2. Thus, the price elasticity of demand is so that the percent change in quantity demanded is 12%. A 12% decrease in quantity demanded represents 100,000 × 0.12, or 12,000 sandwiches.