Question

Draw a picture that shows the income and substitution effect for a decrease in the price of good X. Assume that good X us a normal good. Be sure to place good X on the horizontal axis and explain your picture well.

Answer 1

The substitution effect is change in the demand of a good due to the change in the rate of exchange between the two goods. In other words, when the price of a good changes the rate at which one can exchange one good for another also changes. The income effect is the change in the purchasing power of the income due to the change in the price of a good.

In the following diagram the movement from point A to point B represents the substitution effect and movement from point B to Z represents the income effect and the total effect is reflected by the movement from point A to Z.

The pivot represents the situation where after the change in the price of good X the consumer is compensated with enough income so that the original bundle at point A is just affordable for the consumer. However, due to the change in the price the A bundle is no longer the optimal bundle and the indifference curve intersects the pivoted line. On the pivoted budget line, the new optimal bundle is at point B. The substitution effect represented by movement from A to B shows how the consumer substitutes one good for the other when a price changes but purchasing power remains constant.

The second stage of price adjustment is shown by the parallel shift of the budget line. The final consumption bundle is at point Z. The impact of the decline in the price of good X has been that the consumption of good X has increased while that of good Y has declined. This is because with the decline in the price of good X rate of exchange between the two goods has changed leading to people buying more good X at the cost of good Y. Simultaneously the increase in the purchasing power of the individual due to the decline in the price of good X has also increased the consumption of good X.