Question

. Draw a concept graph to show the substitution effect (SE), income effect (IE), and total effect (TE) of

     an increase in the price of X on the demand for X with X to be an inferior good and Y to be a normal

     good

Answer 1

As X is an inferior good. So, an increase in income of the consumer would lead to a fall in the demand for good X and increase in the demand for good Y. Income Elasticity for Good X is negative and for good Y is positive.

An increase in the price of good X would rotate the Budget Line inwards. From Old Budget Line to New BL as shown in the graph below. Initially, the consumer was in equilibrium at point A where IC is tangent to the old BL. Because of an increase in the price of inferior good X, the budget line rotates inwards and the new equilibrium point is B. The shift from Point A to Point B is known as Substitution Effect which occurs due to an increase in the price of good X.

Now, to keep the individual on the same IC we draw a hypothetical budget line parallel to New BL. Consumer shifts from Point B to Point C as his real income increases. The shift from Point C to Point B is known as Income Effect. An increase in the price of X would induce the consumer to buy more X and therefore, the income effect is positive.

The negative SE is stronger than the positive IE making the overall Total Effect to be negative.

TE = SE + IE

SE > IE

TE is Negative

Quantity of ON Тc, TIC, -NewBL - Old Budget Line Quantity SE