Question

1. When you go to have your special game bird feed mixed, you find that the price of barley has gone down while the price of corn (the other part of your feed mix) is unchanged. You decide to change your mix. Graphically (sketch) and verbally disaggregate this change into the Substitution and the Income Effect. (you can use either Hicks or Slutsky methods. draw graph or use a computer program, label graph)

Answer 1

Ans

Initial budget line is PQ. As price of barley falls price line shifts to PR. To decompose price effect into substitution and income effect we draw ST parallel to PR. This reflect new prices but same real income as reflected by initial budget line PQ. Initial equilbrium was at A. Movement from A to B is due to substitution effect because we substitute cheap barley For corn as price of barley has fallen even if our real income is kept constant. Movement from B to C is due to income effect as real income has risen due to price fall in reality.