Question

explain the meaning of substitution effect and income effect. Show how to decompose total effect of a price change into substition effect and income effect in a figure?

Answer 1

Other goods Movement from A to B shows substitution effect Movement from B to C shows income effect In this case we have drawn the preferences of a consumer using indifference curve and budget line and initially the consumer equilibrium lies at A where the optimal bundle is (x1, yl). Here two goods, good X and Other goods, shown by Y, are consumed. Now consider a fall in price of good X M/Py There is a substitution effect of a price fall where the consumer is likely to consume more of a good whose price has fallen. This is shown by a movement from A to B. There is an income effect as well where a price fall has increased real income of consumer so that she can now consume more of both goods. This is shown by a movement from B to C. Total effect is shown from A to C IC2 All else equal, this implies that the price effect, cumulative of substitution effect and income effect, increases the consumption of good X. At the same time, consumption of other goods is also increased. The new bundle at C has more of both the goods. This shows that as price falls and quantity demanded of a good rises, the quantity of other goods does not remain unchanged. xl x2x3 MPx M/Px"Good X M/P"