Question

T/F/U. You purchased a $200 furniture piece from a no-name website. It never arrives and the site will not send you a new one. You are out $200. You really need this furniture piece, however, and so you take the hit and decide to spend another $200 to get the furniture piece. The income effect will be LARGER than your substitution effect. Draw and explain a graph that comports with your answer. Your graph needn’t have numbers on the axii, but you must show and explain the relative distances for an income and substitution effect consistent with your explanation.

Answer 1

If there is a purchase of $200 furniture piece and it never arrives and the site will not send you a new one. Further, there is $200 out. In this situation, income effect will be LARGER than substitution effect. It can be easily understand by following diagram.

As shown in above diagram, income effect is LARGER than substitution effect. The quantity of furniture Q₁ to Q₂ is our substitution effect and quantity of furniture Q₂to Q₃ is our income effect.

Initially, When income is M , the equilibrium is attained at point E₁. When, there is a purchase of $200 furniture piece and it never arrives and the site will not send you a new one and $200 out, the income of consumer decline to M-$200. The substitution effect is reflected at the tangent point on the initial indifference curve IC₁ at point E₂.

In order to draw Income effect, we draw a line parallel to the point E_2.. The equilibrium is attained at point E₃.

Therefore, income effect will be LARGER than substitution effect.