Shin likes to spend a (relatively small) portion of his income on vacations to Cabo San Lucas (a popular resort area in Mexico)

Question

On these trips, he either stays at a four star resort with panoramic ocean views or a more modest, and slightly deteriorating hotel in the noisy part of town. Understandably, the four star hotel is significantly more expensive. Suppose that the four-star hotel costs $5000/trip while the hotel costs just $500/trip. In recent years, the price of airfare has risen significantly, a change that effects the cost of his trips the same regardless of where he stays. Suppose that airfare has increased from $300/trip to $1000/trip. Why is it that following the higher travels prices, Shin is likely to spend more of his vacations at the four star resort when he travels. (Assume that the hotel rates and Shin's preferences are fixed).

Answer 1

This is an application similar to Shipping the Good Stuff Away. First, consider how the relative prices have changed between the two types of trips following the increase in travel costs. The ratio of prices between trips to the 4-star resort and the hotel is, say, initially p1/p2, where p1 > p2 Following the increase in flights, both prices increase by the same amount, call this s, so that the ratio becomes (p1 + s)/(p2 + s) < p1/p2.
With income and preferences unchanged, the substitution effect leads to Shin selecting more 4-star trips and less cheap hotel trips. The income effect could lead to the reverse occurring, but since the portion of income is small, the income effect is likely to be smaller than the substitution effect.