Question

Paul plays video games only with his young daughter and never alone. For this reason, he always buys exactly two controllers with each purchase of a new gaming console. Otherwise he does not get any utility from owning consoles or controllers.

f) Find the Total, Income and Substitution effect on consoles, associated with the price decrease in consoles. Provide the economic interpretation behind your results. g) Find the Total, Income and Substitution effect on consoles, associated with the price decrease in consoles. Provide the economic interpretation of your results. h) Find the Total, Income and Substitution effect on controllers, associated with the price decrease in consoles. Provide the economic interpretation of your results. i) Verify that the Slutsky equation holds for both goods.

Answer 1

Equation : TE = Price effect = substitution effect.

When the price of the consoles (X) fall , the real income of the consumer increases and then he then can buy more of X with the same amount of money.

In the above Diagram , Budget line rotates from AB to AC and we can see that , total price effect (MF) on the x axis (PR) is equal to the sum of income and substitution effect ( PR = PQ = QR) , where PQ is Income effect and QR is Substitution effect. When price of X falls, More of X is Bought than Y and thus resulting in the rotation in the budget line.

Thus , it satisfies the Slutsky Equation of Total Price Effect = Income effect = Substitution Effect.