Question

please explain clearly

Q1: Using an example of a bundle of two goods, graphically illustrate the substitution effect and the income effect if the price of any one good falls.

Answer 1

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We begin by assuming that good 1 and good 2(all other goods) are both normal goods i.e both goods obey the law of demand. Now the initial budget line AB becomes tangent to the initial indifference curve IC1 at point A* where consumption of good X1 is denoted by q1. Now suppose price of good 1 falls and price of all other goods i.e price of good 2 and money income remains the same. Hence the budget line will rotate outward from AB to AC and the new budget line becomes tangent to a higher indifference curve IC2 at point C* where consumption of good 1 increases from q1 to q2 and consumption of good 2 falls as commodity 2 has now become more expensive as compared to commodity 1. Hence consumers will substitute good X2 with X1. The total effect which is given by the movement from q1 to q3 can be decomposed into two parts, the substitution effect and the income effect. Now if the consumer's income remains same, then he will be on the same indifference curve IC1 but as price of good 1 has falls, hence to maximise utility at point B* , the slope of the indifference curve now should be equal to the new price ratio or will be equal to the slope of the new budget line. Hence we will draw a hypothetical budget line A'C' which will be parallel to the new budget line AC but will be tangent to the initial indifference curve IC1 at point B*. Hence as price of good 1 has declined, the consumer at point B* will substitute good 2 with good1. Hence the movement from q1 to q2 is the substitution effect because we held the income level constant.

Now if we allow the income level to change, then there will be a parallel rightward shift of the budget line from A'C' to AC and the new budget line AC will be tangent to a higher indifference curve IC2. As the price of good 1 falls, consumer will feel wealthier and they will purchase higher amount of good 1 and the movement from q2 to q3 will represent the income effect.

And the total of substitution and income effect describes the total effect.