Question

ASSIGNMENT 2 1. With the help of a neat diagram, explain why the SUBSTITUTION EFFECTG is always negative. An intuitive explanation will suffice, as long as you understand that it is based on the assumption of constant real income. 2. Define an Engel curve; draw a diagram for an Engel curve, where the commodity in question is inferior.

Answer 1

Substitution effect of a price change takes into account the effect of change in relative price alone keeping the real income constant.

Consider a decrease in price of X, with a decrease in price of X , the real income of the consumer increases but that is taken away as part of compensating variation , which is the change in total income at the new price level but at the original level of utility.

​​​​​​As shown in the diagram, AB is the Original budget line. As price of X increases, the budget line rotates to AB'. E1 is the original bundle and E3 is the final bundle. Because real income of consumer increases as price decreases, CD is the level of income that represents the same utility as IC1 at the new price ratio. AC is the Compensating Variation that the income has to be adjusted for.

Subsi tuten Eeet in omu eet TO tal ucu bfeet

Now Substitution effect is always negative to direction of price change because real income is kept constant. With this in mind, as the price of commodity increases / decreases, the quantity demanded will move in opposite direction i.e. decrease /increase respectively. With the price decrease, and real income constant, the consumer will consume more of a given commodity( E1 to E2 on the horizontal axis) And opposite will happen in case of price increase.

2)

An Engel curve gives the relationship between Equilibrium demand of a commodity and income , keeping the prices of the commodities and preference function constant. An Engel curve is generally upward sloping for a normal good case, as the quantity demanded increases with an increase in income. But in case of an inferior good, As income increases , the quantity demanded decreases as consumer moves towards consumption of better quality goods.

Hence Engel Curve of an inferior commodity is downward sloping because we move leftwards on horizontal axis.

Budget line shifts from AB to A'B' and optimal consumption of commodity X moves from X1 to X2. The corresponding Engel Curve is drawn below.

-IC Commatutu 2 CNPROR) neomg M27 MI M2 M 1 X