Answer to Question #316376 in Macroeconomics for Ayeyi

Question

With the aid of appropriate diagram, illustrate income and substitution effect for an increase in price of goods x

Answer 1

The consumer’s original equilibrium is E₁. At this point, the budget line M₁N₁ is tangent to the indifference curve IC₁. Suppose the price of commodity X (normal goods) decreases and other things remain the same. The price decline shifts the budget line to M₁N₃. Consequently, the consumer moves to new equilibrium point E₃. Consumer’s movement from E₁ to E₃ is the total price effect. Let us eliminate the income effect from the price effect by following Hicks’ version. To do so, we draw an imaginary budget line M₂N₂, which is tangent to IC₁ at E₂. E₂ equilibrium point after the elimination of the income effect.

Hence, total price effect

Substitution effect = X₁X₂

Income effect =X₂X₃