Question

1. Explain in words how we need to change the budget constraint graphically in order to illustrate the substitution effect. Do the same for the income effect.

Answer 1

Answer : Budget constraint shows the consumers' ability to purchase goods and services at current prices. Let the consumer purchase two goods : Good A and Good B.

In case of substitution effect if price fall for a good then the consumer's ability increase to purchase more quantities of this good. Similarly, if price rise then consumer's ability decrease to purchase more quantities. When consumer's ability to purchase increase for a good then the budget constraint linearly shift to rightward only for that good. When consumer's ability to purchase decrease for a good then the budget constraint linearly shift to leftward only for that good. But the budget constraint remains same as before for other good. Ultimately, we can say that after changes in budget constraint due to substitution effect the changes in budget constraint looks like cone. Let here the price level falls for Good B. As a result, the budget constraint linearly shift to rightward only for Good B but the budget constraint remains same as before for Good A. Thus, graphically the budget constraint change for substitution effect.

In case of income effect if income increase for consumer then the consumer's ability increase to purchase more quantities of all goods. Similarly, if income decrease then the consumer's ability decrease to purchase more quantities of goods. Hence when consumer's income increase then the budget constraint parallelly shift to rightward. When consumer's income decrease then the budget constraint parallelly shift to leftward. Here this means that if consumer's income increase then the consumer purchase more quantities of both goods : Good A and Good B. But if consumer's income decrease then the consumer purchase less quantities of both goods : Good A and Good B. Thus, graphically the budget constraint change for income effect.