Question

Brigitte purchases two goods: gummy bears and M&M’s. She has a diminishing marginal rate of substitution of gummy bears for M&M’s. Let x denote the amount of gummy bears purchased and y the amount of M&M’s purchased. Suppose the price of gummy bears decreases from P x 1 to P x 2 .

On a clearly labeled graph, illustrate the income and substitution effects of the price change on the consumption of gummy bears.

Do so for each of the following cases:

a. Case 1: Gummy bears and M&M’s are normal goods.

b. Case 2: The income elasticity of demand for gummy bears is zero. M&M’s is a normal good.

c. Case 3: Gummy bears are inferior goods, but not Giffen goods. M&M’s is a normal good.

d. Case 4: Gummy bears are Giffen goods. M&M’s is a normal good.

Graph please!!!!!!! Though the answer has already been answered, I can't figure out what does the comment mean. Graph please!

Answer 1

The figure about Income effect and Substitution effect of given commodities are given below;

The effect of a change in the price of one of the purchasable commodities can be create income and substitution effect. In above figure our consumer Brigitte consume two goods gummy bears and M&M’s and faced with a budget line AB. She has a diminishing marginal rate of substitution of gummy bears for M&M’s. Here, she is in equilibrium at point 1 where she consumes 'q' of gummy bears. Now, the price of gummy bears (commodity x) decreases, while money in­come and the price of M&M’s (commodity y) re­main the same. Brigitte’s new budget line is now AC and her new equilibrium is at point 3 on indifference curve L1, where M&M’s are purchased.

The substitution effect shows the change in the consump­tion of x which occurs when its price and the relative prices of x and y change. When there is a change in relative price the consumer tends to substitute x which is now relatively cheap for y, which is now relatively expensive, although there is no change in the absolute price of y.

The income effect shows the changes in quantity demanded of x resulting from the change in real income that occurs when the price of x changes (falls) while money income is held constant by the assumption of ceteris paribus.

If we hold the con­sumer’s real income constant, she will stay on the old indifference curve L1, and continue to enjoy the same level of satisfaction as before the change in relative price. However, she will not maximise satisfaction at point 1, because there has occurred a change in relative price. So, she will select the point on the curve where the new relative price of gummy bears in terms of M&M’s is equal to MRS. This occurs where the indifference curve is tangent to the line A1C1 which has same slope as AC. Thus the point 2 is the level where the consumer get maximum satisfaction. This shows that her equilibrium purchase of gummy bears is q_2. This implies that the consumer is just enable to enjoy the same level of satisfaction at the new set of q₁q₂. This is the substitution effect of a change in the price of gummy bears.

Since we have a clear idea of the total effect of the price change, we can easily determine the size of the income effect. It is just the difference between the total income in quantity q₃-q₂ minus the substitution effect of q₂-q₁ gummy bears.

Now let's discuss about the given cases.

a) Case 1: Gummy bears and M&M’s are normal goods.

Normal goods are goods which demand increases when income increases. Suppose the price of gummy bears decreases from Px1 to Px2. Thus the real income of the consumer changes from lower to higher, this will make her purchase more of good x. But in the case of good y there is no change in price and income. Therefore it will remain constant. The figure is given below;

b) Case 2: The income elasticity of demand for gummy bears is zero. M&M’s is a normal good.

Zero income elasticity means if the quantity demanded for a particular commodity will be constant even if there is an income increase or decrease. Here because of the fall in price of commodity x the consumer's real income rises. But her cunsumption on commodity x will not change because of the zero income elasticity of commodity x. About commodity y also no change will occur. Because there is no change in price and income.

c) Case 3: Gummy bears are inferior goods, but not Giffen goods. M&M’s is a normal good.

Here gummy bears are inferior goods , but not giffen goods. An inferior good is the good which demand is become lesser when income rises. Here, we assume gummy bears are the inferior goods. Hence, a fall in price will not create any rise in its demand also reduce the demand which will creates a rise in commodity y.

d) Case 4: Gummy bears are Giffen goods. M&M’s is a normal good.

giffen goods are those goods whose demand rises with the increase in price and viceversa. they don't have close substitutes. Here, the price fall of the commodity x' s demand will also decreases. And commodity y will be rise.