Question

1. Suppose you derive utility from Food (F) and Clothing (C). Your preference exhibits diminishing MRS between F and C.  Let’s put F on the Horizontal axis and C on the vertical axis.

e. If price of Food decreases, show the IE and SE on a separate diagram if F is an inferior good.

f. If price of Food decreases, show the IE and SE on a separate diagram if F is a Giffen  good.

Answer 1

In the diagram , initially AD is the budget line where E is the equilibrium point where IC1 becomes tangent to AB and OQ1 amount of food is consumed . If the price of food falls , the budget line pivots to AC where the new equilibrium point is G and quantity of food has increased to OQ3.

To break the price effect into income and substitution , we reduce the income of the individual by an amount that he reaches his original level of satisfaction IC1 . The new budget line is BH which becomes tangent to IC1 at point f where OQ2 Amount of food is consumed . Since the price has fallen , food is substituted for clothes so amount of food consumed increases from oq1 to oq2 . This is the substitution effect.

Now if the income of the consumer is given back such that he reaches AC line , equilibrium moves from point f to G and the quantity of food consumed falls from oq2 to oq3 . Since food is an inferior good , the quantity of food falls as a result of income effect .

Since incase of inferior good , substitution effect > income effect consumption of food increases as a result of fall in price .

F)

In the diagram , initially AD is the budget line where R is the equilibrium point where IC1 becomes tangent to AD and OQ1 amount of food is consumed . If the price of food falls , the budget line pivots to AC where the new equilibrium point is T and quantity of food has decreased to OQ3.

To break the price effect into income and substitution , we reduce the income of the individual by an amount that he reaches his original level of satisfaction IC1 . The new budget line is BH which becomes tangent to IC1 at point S where OQ2 Amount of food is consumed . Since the price has fallen , food is substituted for clothes so amount of food consumed increases from oq1 to oq2 . This is the substitution effect.

Now if the income of the consumer is given back such that he reaches AC line , equilibrium moves from point S to T and the quantity of food consumed falls from oq2 to oq3 . Since food is an Giffen good , the quantity of food falls as a result of income effect .

Since incase of inferior good , substitution effect < income effect ,consumption of food decreases as a result of fall in price .