Exam 7: Income and Substitution Effects in Consumer Goods Markets

Every necessity is a normal good,but not all normal goods are necessities.

Your drink budget is entirely split between bottled water and fancy liqueurs,and your tastes are quasilinear in bottled water.In an attempt to get people to drink more water,the government introduces a subsidy that lowers the price of bottled water. a.In a graph with bottled water on the horizontal and fancy liqueurs on the vertical axis,illustrate your before-subsidy budget and your optimal bundle A. b.As a result of the water subsidy,I notice you consume more fancy liqueur.Illustrate this in your graph using income and substitution effects. c.You and I are good friends,in part because I confided in you some time ago that I,too,have tastes that are quasilinear in water.(Nothing bonds like quasilinearity!)But,after the subsidy is introduced,you observe that I,unlike you,have reduced my consumption of fancy liqueurs.Your other friends claim that this is proof that our friendship is based on a fiction --- that I cannot possibly also have quasilinear tastes.Illustrate in a graph why your friends are wrong. d.If we both have quasilinear tastes,can you explain what the fundamental difference in our tastes is that accounts for the difference in behavior?