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Preference Map

Bob buys milkshakes and hamburgers. The price of a milkshake is 5 dollars, and the price of a hamburger is 1 dollar a burger. Each month, Bob spends all of his income and buys 10 milkshakes and 20 hamburgers. Next month the price of a milkshake will fall to three dollars and the price of a hamburger will rise to 2 dollars. Utilizing a preference map, use a graph to answer the following.

a. Will Bob be able to buy 10 milkshakes and twenty hamburgers next month

b. Will Bob want to buy 10 milkshakes and 20 hamburgers. WHY?

c. Which situation does Bob prefer? milkshakes at 5 dollars each and hamburgers at 1 dollar each or milkshakes at 3 dollars each and hamburgers at 2 dollars each.

d. If Bob changes the quantities that he buys which will he buy more of and which will he buy less of?

e. When the prices change next month will there be an income effect and a substitution effect at work or just one of them. Explain

Solution Preview

Bob's income is $70. With the new prices, the cost of 10 milkshakes and 20 hamburgers is still $70. However, Bob will not want the same bundle of goods. There are logical and mathematical reasons for this. Logically, the opportunity cost of a hamburger is now more in terms of milkshakes. It makes sense that a person will want more of the good when its opportunity cost falls. Mathematically, the bundle of goods which Bob purchases is at the intersection of the utility curve and the budget constraint. If the price of one of the goods ...