Question

20. a. Demonstrate how an increase in income affects spending on a normal good using an Income-consumption curve, a demand curve and an Engle curve. Make sure all of your graphs are well labelled and briefly explain the effect you are demonstrating on each one

b. The price of a good decreases. Explain how this would affect the demand for a good by discussing both the substitution effect and the income effect of the price change.

Answer 1

Income effects is changes in equilibrium of consumption of two goods ,if their income increases, given the price of two goods. Income consumption curve shows the locus of combination of two goods that can be purchased by consumer due to changes in income of the consumer ,given the prices of two goods . Plot commodity X on horizontal axis and commodity Y on vertical axis .Suppose there are two goods, X and Y ,consumer is initially equilibrium at point A where budget line PL1 and indifference curve IC1 intersects. At this income consumer purchases X1 and Y1 amount of commodity X and Y .Engel curve locus of combination of quantity purchase of a good at various income level. Both X and Y are normal goods. Let us take Engel curve of good X. For this plot commodity X on x -axis and income on y axis. At current income consumer purchase X1 quantity of good X at income level of M1 at point R . If income of the consumer increase to M2 , budget line shifts to P2 and intersects at indifference curve IC2 on point B. At this point consumer purchase X2 of good X and Y2 of good 2 . At this equilibrium point ,consumer purchases X1 quantity of good X at M2 level of income at point S. Again consumer income increased to M3, budget line shifts to PL3 and intersects on new indifference curve IC3 on point C. At this point consumer purchases, X3 amount of good X and Y3 amount of good Y. On this new new equilibrium consumer purchases X3 amount of good X at M3 level of income on point T. By joining the points A,B, C, we will get income consumption curve. By joining points R,S,T we will get Engel curve of commodity X . If income of consume increases consumer demand for good X will increase, demand curve of commodity X will shift rightward from D to D1. At this point consumer can more amount of commodity X a. Price effect shows the changes in purchase of a commodity as a results of changes in price of that commodity , price of other commodity and income remain same. Substitution effect shows changes in purchase of commodity as a result of changes towards in relative prices and real income become constant. Income effect shows changes in purchase two commodities as a result of changes in income,and prices of the two goods remains same. Suppose consumer is equilibrium at price line PL1 and indifference curve IC1 at point A .If price of good X falls, real income of consumer increases. price line shifts to PL2 and intersects IC2 at point B . In order to find out substitution effect, the increased real income is taken away from the consumer by reducing his money income so as to enable him to stay on same indifference curve. So that compensated price line AB and the consumer is equilibrium at point C