Substitution and income effect custom essay

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Consider the optimal choice of a consumer between two goods, A and B, given prices of the goods, the consumer’s budget and preferences. Suppose the price for good A doubles. Show graphically and explain verbally the ‘substitution effect’ of this change in prices. Now suppose the price for good B doubles as well. Show graphically and explain verbally the ‘income effect’ of this change in prices.
Question D (group question):
(i) The UK national income account [see UK National Accounts: The Blue Book 2007] for 2006 shows the following simplified figures (in £ million at current prices): Private consumption expenditure (incl. non-profit institutions serving households [NPISH]): 828,081; Government consumption expenditure (individual and collective): 286,812; Gross capital formation (incl. changes in inventories): 238,531; Fixed capital consumption: 133,936; Exports of goods and services: 369,691; Imports of goods and services: 424,128; Net factor income from the ‘rest of the world’ [ROW] (net of indirect taxes paid to plus subsidies received from ROW): 17,334; Indirect taxes on domestic products and imports minus subsidies (including taxes paid to and subsidies received from ROW): 144,663. The figures also indicate a statistical discrepancy between output measure of GDP and expenditures approach of £m 635 (Hint: If c is the difference between two numbers a and b, how would you write this as an equation?).
Using these numbers calculate:
(a) Gross domestic product (GDP) at market prices according to the expenditures approach;
(b) Gross domestic product (GDP) at market prices according to the output approach;
(c) Gross national product (GNP) at market prices (taking GDP by its output measure);
(d) Net national product (NNP) at market prices;
(e) National income (NNP at basic prices).
(ii) Suppose the government wants to improve on its income from taxes by increasing taxes on cigarettes from £1 to £2 per pack, which raises the price per pack from £4 to £5. The government, however, is uncertain about the price sensitivity of the demand for cigarettes. Assuming the (direct) price elasticity of this demand to be constant in the relevant domain, it considers two extreme cases of elasticity to explore the range of possible effects: (a) -0.2; (b) -2.0. Calculate the percentage change of total taxes on cigarettes for both scenarios (Hint: The increase in price reduces the demand for cigarettes. Given this decrease in demand and the increase in tax per unit, you can calculate the percentage change in overall taxes.)
? You are expected to write essays on questions A and B applying diagrams as far as possible to explain your arguments. Question C is to be answered by drawing a suitable diagram. But always make verbally clear what you are doing. Question D is a pure calculation exercise. However, you should be able to explain your analytical approach.

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