Question

Income /substitution effects

It is known that Jack considers X to be an inferior good. Graphically show his original and new consumption choice after a drop on the price of X. Be sure to decompose into a substitution and an income effect.

Answer 1

Graphically show his original and new consumption choice after a drop in the price of X. Be sure to decompose into a substitution and an income effect.

It is known that Jack considers X to be an inferior good. Inferior good is one whose consumption decreases with income increases. When the price of X drops the original budget line shifts rightward. In his process how a substitution effect and an income effect work on good X is shown in FIGURE 1.

As shown in the diagram, the original consumer’s equilibrium point is E, when the original budget line BL is tangent to the indifference curve IC1. After a drop on the price of inferior good X, BL shifts to BL' and the new equilibrium is established at point E'' at higher IC 2. As a result, good X decreases by X X'' amount. This portion is called the total price effect and it is the summation of income effect and substitution effect.

Now, having a new a budget line B1 L1 parallel to BL', the income effect can be eliminated. In this process, the consumer is in equilibrium at point E'. Here, the quantity demanded of good X increases by X'' X'. This happened because of the dominance of the substitution effect alone.

In short, the income effect is negative and substitution effect is positive for an inferior good, in this case, good X; and both the effects work in reverse/ opposite direction.