Question

Suppose that the demand curve of a good is vertical over a given range of prices. Draw the corresponding indifference curves and budget lines (assume the indifference curves of this good meets the four assumptions of preference, and the budget line is linear). Is this good a normal good? (Hint: draw the diagram of the process of getting a demand curve, figure out what substitution effect and income effect should be, and whether income effect is positive or negative.)

PLEASE ATTACH GRAPHS!

Answer 1

The above diagram shows the derivation of a demand curve (Blue line) which is vertical at some range of price.

when the prices fall from P1 to P2 the budget line shifts from AB1 to AB2 leading to an increase in the quantity from Q1 to Q2. However, any fall in prices beyond P2 does not increase the quantity consumed. The units of good consumed remain at Q2 for all the subsequent fall in prices.

Using the first figure we can see that the income effect of this good is always positive (Check for yourself)

When the price falls from p1 to p2 the substitution effect is negative and the income effect is positive. Since the SE<IE, therefore there is an increase in the quantity of the good. However, beyond P2, the two effects IE and SE are equal and opposite so they cancel out each other and the total price effect becomes 0. This is why there is no change in the quantity purchased.

Therefore, the given good is a normal good.