Question

Suppose Bailey consumes pedal bikes and e-bikes. The price increases for pedal bikes and Bailey continues to purchase the same quantity as before the price increase. Illustrate graphically the price-consumption curve and pedal bike demand curve on two separate graphs given this information. Discuss the directions and magnitudes of the income and substitution effects. Are pedal bikes normal or inferior for Bailey? Explain

Answer 1

The price consumption curve shows the relationship between the price and consumption of a certain good.
In this the consumption of pedal bikes remain same despite increase in price this denotes that the Price Consumption Curve (PCC) is vertical in nature and the corresponding demand function is also vertical in nature and quantity demanded remain fixed despite of price.
The PCC and demand curve D is given as follows

Now the increase in price of pedal bikes reduce the consumption of pedal bikes if the consumer want to stay in the same Indifference Curve (IC). He substitutes some pedal bikes with e bikes in order remain in same IC. This is the Substitution effect which is negative in this case as it reduces the consumption from Qo to Qi. The budget constraint also shifts from AB to A'B'.
This increase in price also shows a apparent increase in income and the budget constraint shifts from A'B' to A"B increasing the consumption from Qi to Qo .
Hence Income effect is positive in this case and exactly equal to the Substitution effect which makes the price effect zero.
The figure is given below to depict the effect.

Pedal bike in this case is normal good as the income effect is positive i.e. as the income increases the demand for the good also increases.