Sarah spends all of her income on apples and pears. She thinks that apples and pears are perfect substitutes; one apple is just as good as one pear. Apples cost $4 a unit and pears cost $5 a unit.
1. If the price of apples decreases to $3 a unit, will Sarah buy more of them? What part of the change in consumption is due to the income effect and what part is due to the substitution effect?
2. If the prices of apples and pears are respectively pa = $4 and pp = $5 and if Sarah has $120 to spend, draw her budget line in blue ink. Draw the highest indifference curve that she can attain in red ink, and label the point that she chooses as A.
3. Now let the price of pears fall to $3 a unit, while the price of apples does not change. Draw her new budget line in black ink. Draw the highest indifference curve that she can now reach with red ink. Label the point she chooses now as B.
4. How much would Sarah's income have to be after the price of pears fell, so that she could just exactly afford her old commodity bundle A?
5. When the price of pears fell to $3, what part of the change in Sarah's demand was due to the income effect and what part was due to the substitution effect?