In the following figure, Daniel has an income of $40 per month. He spends his income on either Potato Chips or Coke. The price of Potato Chip is $5 per bag and the price of Coke is $4 per bottle.
a) Graph Daniel’s budget constraint with potato chips on the vertical axis. Also write down the corresponding budget constraint equation.
b) Then suppose that Daniel’s income increases to $60, what’s the change of Daniel’s budget line?
c) Shortly after the increase of Daniel’s income, the price of potato chips falls to $3 per bag. Coke’s price remains the same. Draw Daniel’s new budget constraint.
d) Consider budget constraints in part (b) and (c). Suppose Daniel is initially consuming at point A. After the price change in part (c), Daniel chooses the consumption bundle C. Indicate what portion of the change corresponds to the income effect and what part corresponds to the substitution effect.
e) Are potato chips a normal good? Why?
f) Is Coke a substitute for potato chips? Why?