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Fact 9.3.3
Jim has made his best affordable choice of muffins and coffee.He spends all of his income on 10 muffins at $1 each and 20 cups of coffee at $2 each.Muffins and coffee are ordinary goods.Now the price of a muffin rises to $1.50 and the price of coffee falls to $1.75 a cup.
-Refer to Fact 9.3.3.When the price of a muffin and the price of a cup of coffee change,
A)there is a substitution effect but no income effect.
B)there is an income effect but no substitution effect.
C)there is neither an income effect nor a substitution effect.
D)there is both a substitution effect and an income effect.
E)Jim remains on the same indifference curve.

Question

Quizplus · Accepted Answer

The rise in the price of muffins will lead Jim to substitute muffins with a cheaper alternative, which is coffee. This is the substitution effect. However, the increase in the price of muffins will also reduce Jim's real income since he would have to spend more money to buy the same quantity of muffins as before. This reduction in real income will lead to a decrease in purchasing power and reduce the amount of both muffins and coffee that Jim can afford. This is the income effect. Therefore, there is both a substitution effect and an income effect when the price of muffins and coffee change.

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