Jim buys only bananas and CDs. Suppose that Jim's income is $40, bananas cost $0.80 per pound, and CDs cost $8 each.
(a) Write the equation for Jim's budget constraint and graph it.
(b) Suppose that Jim's optimal consumption bundle is 10 pounds of bananas and 4 CDs. Verify that he spends all of his income on this bundle. Illustrate this consumption choice on your graph for part (a), assuming that Jim's indifference curves are downward-sloping and convex.
(c) Suppose the price of CD's decreases to $5. Write the equation for Jim's new budget constraint. On a new graph, illustrate the impact of this price change on Jim's budget constraint (by drawing Jim's old and new budget constraints).
(d) Assuming that (1) bananas are a normal good, and (2) the income effect dominates for banana consumption, what is the effect of the price decrease of CDs on Jim's consumption of bananas? Explain why. On your graph from part (c), show the impact of the change in the price of CDs on Jim's consumption bundle, by decomposing it into the income and substitution effects. Carefully label the income effect, substitution effect and total effect on banana consumption on your graph (label the relevant consumption bundles, mark the sizes of each effect along the relevant axis, and use arrows to indicate the direction of each effect)