Suppose the price of cheese has recently risen from $4 to $6 per pound, while the price of fruit has fallen from $8 to $6 per pound. During this time, Miguel's income has stayed fixed at $48 per week. Before the price changes, Miguel had been buying 4 pounds of cheese and 4 pounds of fruit per week. Since the price changes, he has been buying 2 pounds of cheese and 6 pounds of fruit weekly. Assuming Miguel's preferences have not changed, is it possible to say whether the price changes have made Miguel better off or worse off? Explain.
What will be an ideal response?
After the price changes, Miguel could still purchase 4 pounds of cheese and 4 pounds of fruit, because this basket still costs $48 under the new prices. Since Miguel chose not to continue purchasing this basket and instead chose to purchase a new basket, we can conclude that he must prefer having 2 pounds of cheese and 6 pounds of fruit to having 4 pounds of each good. Therefore, the price changes have made Miguel better off. Alternatively, one can use a Laspeyres price index to show that Miguel is better off. In this situation, a Laspeyres price index would report no change in the cost of living (since 4 pounds of each good costs $48 both before and after the price changes), so Miguel is better off since a Laspeyres price index makes price changes seem worse for consumers than they really are.
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