Question

# Suppose a consumer only consumes two goods. There is a price drop of good 1 and...

Suppose a consumer only consumes two goods. There is a price drop of good 1 and the quantity demanded of good 1 increased from 5 unit to 20 unit, the substitution effect is 10 unit. Use a graph to show the income effect and substitution effect for these two goods. Label the direction of substitution effect and income effect and calculate income effect.

In following graph, AB is original budget line which is tangent to initial indifference curve IC0 at point X with quantity of Good 1 being 5 units. When price of Good 1 falls, budget line shifts to AC, intersecting new indifference curve IC1 at point Z with higher quantity of Good 1 (20 units). Total effect of this price fall is movement from point X to point Z (= 20 - 5 = 15 units).

To find substitution effect we draw line DE, parallel to AC but tangent to original indifference curve IC0 at point Y. Substitution effect is movement from point X to point Y (= 10 units = 15 - 5) and Income effect is movement from point Y to point Z (= 20 - 15 = 5 units).