Question

Suppose Joe spends all his money on bread and books. When the price of bread decreases, analyze the substitution effect and income effect on bread (draw the graph and explain). Please show your analysis of the two effects on books as well.

Answer 1

Analysis:

1. As price of bread falls, it becomes relatively cheaper , therefore, substitution effect leads to increase in its demand. Also consumer's real income increases, therefore, income effect also leads to increase in its demand and therefore total price effect is substitution effect plus income effect.

2. As price of bread falls, books become costlier in relative terms, therefore, substitution effect leads to decrease in its demand. Secondly, increased real income of consumer causes increase in its demand, therefore, income effect causes increases in its demand. Total price effect is income effect minus substitution effect.