Question

suppose the price of compact disks(CD) is $10 each. Suppose the price for downloading tracks of music legally is $1 for each song. Suppose Susan has $30 to spend each month on music. Draw the budget constraint with CDs on the horizontal axis. Suppose the price of CDs fall to $5. Draw the budget line. Show using the indifference curve the beginning and the ending maximizing choices and the substitution and income effect given that CDs are inferior but not Giffen goods. label the subsitution and income effects.

Also if CD rises to $15 and is normal good

if CD rises to $15 and is inferior good

if CD rises to $15 and is Giffen food

if cd falls to $5 and is normal good

if cd falls to $5 and is Giffen good.

Answer 1

AB is the initial budget line when the price of CDs is $10. AC is the final budget line when the price is $5. (How to plot? Take the intercept points: how many CDs if all $30 is spent on CDs at the given price; and how many tracks if all $30 only on tracks at the given price of $1).

For normal goods, the substitution and income effects are positive (and thus, on the same direction). For inferior goods, substitution effect is positive but the income effect is negative; however, the net effect (Price Effect) is positive (i.e., SE>IE). For Giffen goods, which is a special case of inferior goods, SE is positive, IE is negative and the net effect is negative (i.e. IE>SE).

The three cases for a price fall are drawn below. I have used the Slutsky decomposition to show the effects. One can use Hicks decomposition too. A parallel shift reveals the income effect, while a pivoted budget line around the initial IC shows the substitution effect.

In case of price rise, you can just interchange the initial and final budget lines, draw a budget line parallel to the final budget line that also pivots around the initial IC. The directions (arrows in the diagrams) of SE and YE are reversed. Let me know if you need help with this.