Ethan enjoys buying books and going to the movies. He has income of $150 to spend on these two goods each month. The price of a book is $15 and the price of a movie ticket is also $15. He currently consumes four books and six movies each month. If the price of a book increases to $20, which of the following is true?
A)The substitution and income effects both predict Ethan will consume more of both goods.
B)The substitution and income effects both predict Ethan will consume less of both goods.
C)The substitution effect predicts Ethan will consume more books and fewer movies, and the income effect predicts he will consume less of both goods.
D)The substitution effect predicts Ethan will consume fewer books and more movies, and the income effect predicts he will consume less of both goods.

Question

Quizplus · Accepted Answer

The substitution effect occurs because the relative price of books has increased, making movies relatively cheaper, so Ethan is likely to substitute away from books towards movies. The income effect occurs because the real purchasing power of Ethan's income has decreased (books, which he buys, have become more expensive), leading him to reduce consumption of both goods, as his effective income is lower.

Ethan Enjoys Buying Books and Going to the Movies