Question

2. For the following graphs, suppose that the price of Good 1 changes so that the budget line shifts from BL to BL2. Identify the income and/or substitution effects on the graphs, as labeled by E1-E5. (Note: the purple lines are indifference curves) ---- --- Units of Good (a) Variety Units of Good 2 Units of Good 1 (b) Perfect complements (c) Perfect substitutes

Answer 1

a). Here the initial budget line is BL1 and the initial equilibrium is A. Now, as the price changes the new budget line is BL2 and the new equilibrium point is C. So, the movement from point A to C shows the total effect of price change.

Uits of Good Uits of Good

Now, to decompose the total effect into SE and IE. We have to reduce the income of the consumer such that the consumer will get back to the initial utility. So, the movement from “A” to “B” shows the SE the movement from “B” to “C” shows the IE. So, “E1” shows the SE and “E2” shows the IE.

b). Here the initial budget line is BL1 and the initial equilibrium is A. Now, as the price changes the new budget line is BL2 and the new equilibrium point is B. So, the movement from point A to B shows the total effect of price change.

Unit of Good 2 Unit of Good 1

Now, to decompose the total effect into SE and IE. We have to reduce the income of the consumer such that the consumer will get back to the initial utility “U1”. So, the movement from “A” to “B” shows the IE. So, “E3” shows the IE and SE is zero.

c). Here the initial budget line is BL1 and the initial equilibrium is A. Now, as the price changes the new budget line is BL2 and the new equilibrium point is C. So, the movement from point A to C shows the total effect of price change.

Units of Good 2 BL E4 Units of Good 1

Now, to decompose the total effect into SE and IE. We have to reduce the income of the consumer such that the consumer will get back to the initial utility “U1”. So, the movement from “A” to “B” shows the SE and the movement from “B” to “C” shows the IE. So, “E4” shows the SE and “E5” shows the SE.