Question

Sarah buy two goods, orange juice and apple juice, which she considers substitutes. Assume Sarah considers both goods normal. Draw a utility-maximization model showing the substitution and income effects of a decrease in the price of orange juice.

Answer 1

Normal good is one, the demand for which increases with a fall in income and decreases with a rise in income.Normal goods have positive income elasticity of demand. Eg bread ,rice etc

In case of normal goods the income effect and substitution effect work in the same direction.Income effect is a change in the demand for goods and services which is brought by a change in the real income of the consumer.Substitution effect induces the consumer to purchase more of the cheap goods.When price of a normal good ie orange juice here ,falls , the purchasing power of individual increases.Income effect here will work in the direction of the substitution effect ie the demand for the good whose price has fallen will increase.

In the fig , PL1 is the budget line and the consumer will be in equilibrium in the indifference curve IC1 at point S.If the price of orange juice falls , the purchasing power will increase and the new budget line will be PL2.The consumer will be in equilibrium at point R which is in the right of S and indicates more quantity will be demanded as price falls.The income effect is positive for normal goods.The substitution effect which is always negative works to increase the quantity demanded of the good if its price falls.Here the income effect and the negative substitution effect work in the same direction ie the quantity demanded increases.