ECON help: Perfect Substitutes and Compensated Price Effects
Hey, I'm having a hard time understanding this econ problem regarding compensated price effects. Here's the question:
This is what I got for a)
Regular- and extra-strength pain killers are perfect substitutes; one extra-strength tablet is equivalent to two regular-strength tablets. In each of the following cases, show graphically the effect of a compensated increase in the price of regular-strength tablets. What do you find from the size of the substitution effect resulting from the increase in price of regular strength tablets?
a) The price of Extra Strength tablet is more than twice the final price of a regular strength tablet
b) The price of an Extra Strength tablet is more than twice the initial price of a regular strength tablet, but less than twice the final price
c) The price of an extra-strength tablet is less than twice the initial price of a regular strength tablet
An increase in price of Extra Strength pills means that the consumer can buy less. To compensate for this, the line (L3) is an outward shift of (L2) shows that the consumer will end up spending his income on regular strength pills
b) is a bit confusing for me. What I drew was the original line (L1), then (L2) which shows the price of Extra Strength > 2* Initial Price of Regular (so you can effectively buy less Extra Strength). (L3) shows the price of extra strength < 2* Final price of regular, and (L4) shows the compensated increase in income, given that Regular strength has effectively grown to be more expensive than Extra Strength. The increase in income allows the consumer to buy more Regular strength
c) I actually have no clue what to do for this question. I've read it over and over to the point where I actually don't understand what it means anymore, apart from: PExtra Strength < 2 * PRegular
So could anyone let me know if I'm on the right path?
Re: ECON help: Perfect Substitutes and Compensated Price Effects
Before worrying about economic theory, start by just thinking about what is going to happen to demand:
if the price of a double strength one is less than twice the strength of a single pill, then only "double strength" will be bought
if the price of a double strength one is more than than twice the strength of a single pill, then only "single strength" will be bought
So, now you know what the total demand effect is.
But you know that: "total demand effect" = "income effect" + "substitution effect"; you can deduce the direction of the income effect (it will be negative, as prices have increased)...now what can you say about the substitution effect?