Income And Substitution Effect

Question 1

For a fall in price Good X…

How to isolate the substitution effect and what does this look like graphically

Answer 1

Hold purchasing power constant

Draw a dotted hypothetical budget line (with new slope) on the original indifference curve and goes through then original bundle A. We are substituting more good X as cheaper.

Question 2

The full effect has not been shown yet.

How to illustrate the income effect graphically, and what assumption do we have to make?

Answer 2

Real income increases as price of good X falls.

So this would lead to a new indifference curve on the new budget line.

Assume good X is a normal good, so as real income rises we buy more.

Question 3

Substitution and income effect is a good is inferior

Answer 3

Substitution and income effect move in opposite directions

I.e when price rises, substitution effect leads to demand goes down, income effect is opposite.

Whereas normal goods, the 2 effects reinforce each other e.g price fall for a normal good, leads to an increase in demand.

Question 4

Slutsky’s effects for normal goods concept

Answer 4

Sub and income effect reinforce each other.

I.e both increase demand for a good when price falls.

(Pg 8 shows this reinforcement following fall in price of X)

Question 5

Slutsky’s effects for income-inferior goods concept (pg10)

Answer 5

Substitution and income effects oppose each other when the price changes.

Question 6

Giffen goods (pg12)

Answer 6

Price falls, demand falls. (Extremely income inferior)

Income effect>sub effect so overall, demand for X is lower than before.

Question 7

Total change in demand (size of sub/income effects)

Answer 7

Δx

Question 8

What kind of good does the substitution effect not apply for?

Answer 8

Perfect complements - since cannot be subbed, they are consumed in fixed proportion.