Question

Harvey sells two goods - cars (Good X) and chairs (Good Y). Illustrate and explain using budget lines and indifference curves the income effect and substitution effect when the prices of cars increase

Answer 1

In following graph, AB is the initial budget line and IC0 is the initial indifference curve which is tangent to AB at point E with initial optimal bundle being (X0, Y0). When price of X increases, budget line rotates inward along horizontal (X) axis to AC. IC1 is the new (lower) indifference curve which is tangent to AC at point G with new optimal bundle being (X1, Y1).

To find substitution effect, a line MN is drawn parallel to AC. Initial indifference curve IC0 is tangent to MN at point F with decomposition bundle being (X2, Y2). In this case,

Total effect (TE) of price change = Movement from E to G

TE for good X = X1 - X0 (< 0)

TE for good Y = Y1 - Y0 (> 0)

Substitution effect (SE) of price change = Movement from E to F

SE for good X = X2 - X0 (< 0)

SE for good Y = Y2 - Y0 (> 0)

Income effect (IE) of price change = Movement from F to G

IE for good X = X1 - X2 (< 0)

IE for good Y = Y1 - Y2 (< 0)