Question 3 - Income & Substitution Effects - Subsidy I (6 points)

Suppose Melissa's preferences for books (x) and movie tickets (y) can be represented as U(x, y) = xy.

In 2015, the price of a book is $36, the price of a movie ticket is $16, and Melissa has $144 to spend.

1. What bundle would Melissa choose to purchase? Illustrate this bundle in a diagram with the budget

line, the indifference curve, and label the bundle A. (1.5 points)

In 2016, to encourage reading, the government introduces a subsidy of $20 on each book, so the price of each

book now is $16.

2. Find Melissa's new best bundle (bundle B). Illustrate the new budget set and point B in the same

diagram as part 1). (1.5 points)

3. Illustrate the substitution and income effects associated with the subsidy. Use these two effects to

explain why the subsidy of books doesn't affect demand for movie tickets. (2 points)

4. Suppose the price of books is back to $36 each. If Melissa receives a gift equal to the amount that the

government is subsidizing her, is she better off or worse off, compared to when she gets the subsidy?

(1 point)