Question

Suppose Oreos and Hydrox are perfect substitutes, one for one. If Oreos currently sell for 50 cents and Hydrox sell for 75 cents, use both graphs and words to explain income and substitution effects that occur when the price of Oreos to rise to $1.

Answer 1

Suppose Oreos and Hydrox are perfect substitutes one for one. Now as currently price of Oreos I.e 50 cents is lower than the the price of hydrox i.e 75 cents, hence initially consumers will consume only Oreos. Now this is shown in the graph where the initial budget line is AB which is tangent to the initial indifference curve IC1 at optimal consumption bundle point ( X1,0) where X1 is the initial consumption of Oreos and initially consumers are not consuming hydrox.
Now as the price of Oreos rise to $1, the budget line rotates inward from AB to AC which becomes tangent to the new indifference curve at new consumption bundle point (0,X2). Now here as price of Oreos rise to $1, Oreos become expensive than Hydrox. Hence consumers will switch their consumption from Oreos to Hydrox and thus the consumption of Oreos become zero in the new equilibrium. Hence here the movement from point B to point A is due to the substitution effect only and here income effect is zero. Thus the total effect of declining consumption of Oreos from X1 to 0 is due to the substitution effect only.