Question

Suppose Bob consumes pedal bikes and e-bikes. The price increases for pedal bikes and Bob 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 Bob? Explain.

Answer 1

We know, that the price consumption curve (PCC)shows the relationship between the price and consumption of a certain good.
Here, in this case of Bob it is given that the consumption of pedal bikes remain same despite increase in price and 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.
Thus, The PCC and demand curve D for Bob is shown as follows

Now, it is given that the increase in price of pedal bikes reduce the consumption of pedal bikes if Bob wants 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 an apparent increase in income and the budget constraint shifts from A'B' to A"B increasing the consumption from Qi to Qo . Therefore, the Income effect is positive in this case of Bob and exactly equal to the Substitution effect which makes the price effect zero.
The figure shown below depicts the effects:

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