Question

Good X is a normal good. Use indifference curves and budget lines to show the substitution and income effects of a price decrease for Good X. Put “expenditures on other goods” on the Y-axis, and clearly label all lines and curves. Make sure your diagram clearly shows the income effect and the substitution effect, and that you indicate which is the income effect and which is the substitution effect.

b. Give a short one or two sentence explanation of what the substitution effect means. Do the same for the income effect.

Answer 1

(a) In following graph, Y (Expenditure on other goods) and X (good X) are measured vertically and horizontally respectively. AB is the initial budget line and initial utility-maximizing point is point E where initial indifference curve IC0 is tangent to AB with optimal quantity of X being X0. When price of X falls, AB shifts to AC and new utility-maximizing point is point F where new indifference curve IC1 is tangent to AC with optimal quantity of X being X1. Movement from E to F is Total effect (TE = X1 - X0). To find substitution effect, we draw a line parallel to AC, which is tangent to IC0 at point G, with corresponding quantity of X being X2. Substitution effect (SE) is movement from E to G (SE = X2 - X0) and Income effect equals movement from G to F (IE = X1 - X2).

(b) Substitution effect indicates the change in quantity of X demanded because consumers substitute Y by consuming more of good X (which is relatively cheaper), keeping utility unchanged. Income effect indicates the change in quantity of X demanded because consumers have higher purchasing power caused by fall in price of X, which has increased real wealth.