Question

a.Suppose there are two goods, that the prices are given, and that there is a consumer with a certain income. Show in a diagram it is possible to split the effect of price fall on good 1 into income- and substitution effects. Assume that the good is a normal good.

b.If the good had been an inferior good, what would have been different in the graph?

c.If the good had been a Giffen good, what would have beedifferent?

Answer 1

In case of normal income and substitution effect works in the same direction but in some cases income effect does not go in the sane direction while substitution effect will always work in the same direction as customer always choose that good which is cheaper for them.

Case of normal good: Consider the budget line given as AB where the consumer is consuming at point IC1. Assume a case when the price of X falls and the budget constraint shifts to AC where consumer would consume at IC2. If we assume a condition when the income were lower and the budget constraint were XY, then consumption would at level IC3. The income effect and substitution effect is shown below.

Case of Inferior good: Consider the budget line given as AB where the consumer is consuming at point IC1. Assume a case when the price of X falls and the budget constraint shifts to AC where the consumer the consuming at IC2. When we assume a condition if the income level were lower, budget constraint would have been XY where the consumer would consuming at level IC3. the fall in price of good X shifts the consumer from IC1 to IC2 and the income effect is negative.

Case of Giffen Good: This is because the fall in price of an inferior good on which they spend a very large portion of their income causes such a large increase in their purchasing power that creates a large negative income effect. They will therefore reduce the consumption of that good when its price falls since large negative income effect outweighs the substitution effect.