Neville, in Problem 2, has a friend named Algernon. Algernon has the same demand function for claret as Neville, namely q = .02m - 2p, where m is income and p is price. Algernon's income is $5,500 and he initially had to pay a price of $20 per bottle of claret. The price of claret rose to $50. The substitution effect of the price change

Question

Quizplus · Accepted Answer

The substitution effect is calculated by keeping utility constant and adjusting for the change in relative prices. Initially, Algernon's demand is q = .02(5500) - 2(20) = 90. With the price increase to $50, the substitution effect can be calculated using the compensated demand curve, which keeps utility constant. The compensated demand at the new price is q = .02(5500) - 2(50) = 40. The substitution effect is the difference between the initial demand and the compensated demand, which is 90 - 72 = 18.

Neville, in Problem 2, Has a Friend Named Algernon