Question

Suppose that price for Compact Disks (CDs) is $15 each. Suppose the price for downloading tracks of music legally is $1 for each song. Suppose Sophia has $30 to spend each month on music.

1. Draw the budget constraint on a graph with CDs on the horizontal axis. (1 points)
2. Suppose the price of CDs falls to $10. Draw the new budget line. (1 point)
3. Show using indifference curves the beginning and ending utility maximizing choices and the substitution and income effect given that CDs are inferior but not Giffen good. Label the substitution effect SE and the income effect IE on the graph. (4 points)

Answer 1

Solution music Tracks E Initial Choice Initial budget keine 4 EL New Budget line > Ef Here, Income effect of CDs price reduction is negative on the quantity of CDs. Thus, CD is inferior good but not liffen as elebetitution effect overfowers income effect C Final Choire --H ---- LDS T ! EI x X3 X₂ Substitution' I Effect Effect