.Under what conditions does the income effect reinforce the substitution effect? Under what
Conditions does it have an offsetting effect? If the income effect more than offsets the
Substitution effect for a good, what do we call that good?

Martha has $150 of disposable income to spend each week and cannot borrow money. She
Buys milk and composite good. Suppose that milk costs $2.50 per bag and the composite
Good costs $1.50 per unit.
a. Sketch Marthaís budget constraint.
b. What is the opportunity cost, in terms of bags of milk, of an additional unit of the
Composite good

Martha has $150 of disposable income to spend each week and cannot borrow money. She
Buys milk and composite good. Suppose that milk costs $2.50 per bag and the composite
Good costs $1.50 per unit.
a. Sketch Marthaís budget constraint.
b. What is the opportunity cost, in terms of bags of milk, of an additional unit of the
Composite good

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Attachment 41004


The slope of the budget line tells us the number of units of the composite good (0.6) that must be given up in order to get an additional bag of Milk.

The opportunity cost of the composite good is the number of bags of Milk that Martha has to give up to get an additional unit of the composite good. Since she can get 0.6units of the composite good for each bag of Milk that she gives up, she need only give up 1 / 0.6 = 1.6 bags of Milk to get 1 additional unit of the composite good. Thus, the opportunity cost of an additional unit of the composite good is 1.6 bags of Milk .

Shannon, your graph is correct, and your general thinking about the relationship between the line's slope and the opp'y cost of one good in terms of the other is also correct.

But, you're getting the results in your answer backward. Whenever in doubt, just reflect on the prices of the two goods: one unit of milk is $2.50 and one unit of the composite good is $1.50.

So without any econ theory at all, it's clear that giving up one milk unit frees up $2.50, which can then purchase 1 and 2/3 composite good units. Equivalently, purchasing one more milk unit requires $2.50, which means giving up 1.67 comp good units. That's just another way of saying that the opportunity cost of one milk unit is 1.67 composite good units.

A similar thought process shows you the opp'y cost of the composite good in terms of milk units.

So keep the graph but re-think your numbers.

Under what conditions does the income effect reinforce the substitution effect? Under what conditions does it have an offsetting effect? If the income effect more than offsets the substitution effect for a good, what do we call that good?

After the countries of Eastern Europe converted from communism to the market system, they tried to set up share and bond markets. Most of these markets have remained very small, with firms being able to find buyers for their shares or bonds. One economist remarked that the reason these financial markets have been unsuccessful is that ‘the lemons problem has been too great’. What is the economist meant.

Lemon problem in financial markets? - Yahoo!7 Answers