A state is spending $40 million on highway improvements.If the federal government promises to pay the state $0.25 for every $1 spent by the state on highway improvements,and if highway improvements are a normal good,the income effect induces the state to spend _________ on highway improvements; the substitution effect induces the state to spend _________ on highway improvements.

Question

Quizplus · Accepted Answer

The income effect occurs when the purchasing power of the state changes due to the federal government's promise to pay for a portion of the expenses. In this case, the state has more money available for other projects and needs, which could induce them to spend more on highway improvements than they originally planned. Therefore, the income effect induces the state to spend more on highway improvements.

The substitution effect occurs when the relative prices of goods and services change. In this case, there is no change in the price of highway improvements, but the federal government's promise to pay for a portion of the expenses could be seen as a price reduction for the state. This would induce the state to substitute more highway improvements instead of other projects that were originally planned. Therefore, the substitution effect induces the state to spend more on highway improvements.

A State Is Spending $40 Million on Highway Improvements