4. Show income and substitution effect on graph when price of a normal good decreases. (10...

Question

Question

4. Show income and substitution effect on graph when price of a normal good decreases. (10 points)

Answer 1

Answer #1

A decrease in the price of normal goods would lead to a rise in the consumption of such goods. Following is a diagram:

Product A (units) Q2 Q6 Q4 Product B (units) Substitution Income effect effect Overall increase in the quantity demanded

After fall in the price of good B, the budget line shifts outwards. Hence, now new equilibrium is established at indifference curve 2.
After equivalent variation, we draw dotted parallel line, so that the budget line could touch old indifference curve 1.
The movement of Q2 to Q6 shows the substitution effect.
Gap between the Q6 and Q4 is called income effect.
Both effects move in same direction.

Answer 2

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