Question

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.

Answer 1

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).