Substitution and Income Effect (Graph) Illustrate the effect of a price decrease: a. Draw an arbitrary...

Substitution and Income Effect (Graph)

Illustrate the effect of a price decrease:

a. Draw an arbitrary budget line on the (X,Y) plane. Draw \usual" indifference curves (for example,

Cobb-Douglas) and sign the optimal bundle.

b. Now assume that price of Y is unchanged and price of X decreases by 50%. Illustrate the switch to

the new budget line in two steps:

i. Change the slope of the budget line, while the tangency point is still on the original indifference

curve.

ii. Do a parallel shift in order to get to the new budget line.

Sign the new optimal bundle and draw the corresponding indifference curve. Also sign the bundle what

you would get considering only the substitution effect.

c. Evaluate the change in the quantity demanded from X based on your own graph:

i. Is the substitution effect positive or negative?

ii. Is the income effect positive or negative?

iii. Is the total effect positive or negative

d. Based on your answer in part c. decide whether good X is normal, inferior or Giffen. (Note that

in this problem the correct answer depends on how you draw your graph.)

Solutions

Expert Solution

Rahul Sunny answered 1 year ago

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