Currently, Paula is maximizing utility by purchasing 5 TV dinners (T) and 4 Lean Cuisine meals (L) each week.
(a) Graph Paula's initial utility-maximizing choice.
(b) Suppose that the price of T rises by $1 and the price of L falls by $1.25. Can Paula still afford to buy her initial consumption choices? What do you know about her new budget constraint?
(c) Use your graph to show why Paula will choose to consume more L and less T given her new budget constraint. How do you know that her utility will increase?
(d) Some economics define the "substitution effect" of a price change to be the kind of change shown in part c. That is, the effect represents the change in consumption when the budget constraint rotates about the initial consumption bundle. Precisely, how does this notion of substitution effect differ from the one defined in the text?
(e) If the substitution effect were defined as in part d, how would you define "the income effect" in order to get a complete analysis of how a person responds to a price change.