Question

1) A) Use a budget line and Indifference curve to show an initial optimal consumption bundle of onions and peppers. Assume onions are normal goods and peppers are inferior goods. Next suppose the price of peppers increases. Graphically Illustrate and explain the income and substitution effects. B) Using the two prices and two quantities of peppers from the previous part of this problem, construct a demand curve. Explain where your numbers are coming from. Also show the income and substitution effect on your graph.

Answer 1

Conion) goody SOE E, IC, E2 IC2 TE ملکیت con bundle from E, changes to Eq. The movement from E, to Solution :- Arfenisu goods are those whose demand fallo when consumeris income rises. Here it is given that pepper is the inferior good. , The intial optimal consumption bundle is E, as here the budget line and indifference were intersects. Substituhion effect 25-127-7 + Income effect 6-5z + 1 Total effect - 7+1 2-6 B!? B; good x (pepper) here, E, E3=S-E E, to Ez z To E Ezt 622 1.E good x" (pepper , Suppose earlieu price of pepper was $5 then demand was 12, as price increased from $5 to $8 the budget line will sotate inward and a new indifference wire will intersect the new budget line. The consumption Ez is the total effect of price change. Price Conon) Di 0 6 12

Consumption goes down from 12 units to Gunits as inferiou good has become more expensive how and with increase in price real' income has fallen. But, as Ez is on lower indifference wire than E, this means consumer will get tower satisfaction if he consumes bundle Ea. But this is the total effect. To separate the two effects le income offeet and substitution effect we will take a new budget lime B3 parallel to budget line B2 • It is tangent to the initial mclifference Cure IC• This new DC Shows wiat would have happens if with increase mprice of peppele, the imcome also increased. the movement between E, and E3 shows cubstitutioneffect. If we Substract Substitution effect from total effect income effect can be found-ire E to Ezo The compensated demand aume. is drawn by ignoring the income effect. Assuming real income and utility is constant. when we plot the compensated demand curre we take the initial point E, when prüce is less and demand is more. after that we take the second point Ea as it is the substitution effect after decreasing income effect. Here the price is high and demand is less (ive price is 8 and demand is 6) from this we can see demand is downward sloping uurire. The Numbers live price and quantity) are assumed. But, both the devination are linked as discussed above.

With increase in price of inferior good its demand fall. And when we plot it we see, demand curve is a download sloping curve, showing inverse relationship between price and quantity demanded. In compensated demand curve income effect is ignored (here income effect is E3 to E2).

Note:- I.E is income effect

S.E is substitution effect

T.E is total effect.

Hope this was helpful!!