Question

True or False: If pizza and calzones are substitutes, then the substitution effect of a price change will be in a different direction than if pizza and calzones are complements. Explain, using a diagram.

Answer 1

False

Because in Perfect complements there is no substitution effect and only income effect. And in case of perfect substitutes the substitution effect is always negative.

Let us assume that pizza and calzones are x1 and x2 with price 2 and 1 and income of 10

Let the utility function be U(x1,x2) = x1+x2

Budget Constraint = 2x1+x2 = 10

Now if price falls from 2 to 0.5 in case of x1 then there will be a substitution effect. Initially the consumer was choosing Eo but after decrease in the price of x1, the consumer chooses E1.

Below it is shown in the diagram

In case of perfect complements the utility function is

U(x1,x2) = min{x1, x2} at same prices and income as above,

Now if the price of x1 decreases the consumers incomes increases but consumer doesn't shift its consumption, hence no substitution effect and only income effect