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Utility function

$$ U=4{q_1}^{0.5}+q_2 \\ Y=10 $$

$$ p_1=p_2=1 $$

Then $p_1$ rises to 2. I would like to ask how to calculate the substitution effect on the demand for q1?

What I have done is calculate the optimal bundle initially which is (4,6) then subs into the utility function and get $U=14$. However, I am stuck here for calculating the subs effect on $q1$.

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  • $\begingroup$ Which substitution effect? Here are some links that may help you find out what you need to do: wikieducator.org/SUBSTITUTION_EFFECT/Next en.wikipedia.org/wiki/Substitution_effect $\endgroup$ – Giskard Apr 30 '15 at 9:49
  • $\begingroup$ @denesp what i want to find is the quantity of A reduced as a result of the substitution effect. Now I have U=14 But I am not sure how to find that new $$q_1$$ with the utility held constant. $\endgroup$ – UnusualSkill Apr 30 '15 at 9:52
  • $\begingroup$ @UnusualSkill did you follow the link that denesp posted? There is more than one substitution effect. $\endgroup$ – FooBar Apr 30 '15 at 11:26
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You made the right start by calculating the utiltiy at $p_1=p_2=1$.

When we change a price, two things happen. Firstly, one of the goods becomes relatively more expensive, so people substitute away from that good.

Secondly, since the total amount of goods someone can afford is lower when a price increases, it is as if their income went down.

To find the substitution effect, we need to shut down the second of these effects and focus on the first.

It sounds like you are after what is more properly known as the Hicksian substitution effect. To calculate that, we need to compensate the consumer for the aparent loss of income. In other words, we need to answer the following question: "Given $p_1=2$ and $p_2=1$, what income would be needed to achieve the same utility as before (i.e. $U=14$)?" Call the income level that answers this question $\widetilde{Y}$.

Then, all we need to do is calculate the optimal consumption bundle when $p_1=2$, $p_2=1$, and income is $\widetilde{Y}$. The substitution effect is the the difference in $q_1,q_2$ between this new bundle and the first one you calculated.

Hopefully, this is enough to help you figure out the solution.

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  • $\begingroup$ You mean find the Y such that it passes through the original bundle (4,6),which is Y=14? But it seems like when Y =14, I got $$q_1=1$$ and $$q_2=12$$ which is not true, to maintain the same utility, I must have $$q_1=1$$ and $$q_2=10$$ I know this because sub back into the utility function. $\endgroup$ – UnusualSkill Apr 30 '15 at 13:31
  • $\begingroup$ If only you would take the time to read about the two substitution effects, you would realize you are not talking about the same one: wikieducator.org/SUBSTITUTION_EFFECT/Next $\endgroup$ – Giskard Apr 30 '15 at 16:11

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