Consider an increase in the price of good X. The substitution effect for good X
ID: 1190058 • Letter: C
Question
Consider an increase in the price of good X. The substitution effect for good X can be calculated either by holding the utility level constant or by allowing the consumer to buy the old consumption bundle. Give two graphical examples - one in which using leads to a larger substitution effect for X and a second example in which method leads to a larger substitution effect. Consider two goods X and Y. "If indifference curves satisfy the assumption that more is better than less, then both goods cannot be inferior." Provide a proof of the statement.Explanation / Answer
i) Two figures are shown below.
In each of the figures, the price effect is X1X4. In each of the two figures, the price effect is broken into substitution effect and income effect. In each of the two figures, two methods of breaking the price effect are shown:
By holding the utility constant.
By allowing the consumer to buy the old consumption bundle
In the first figure, the substitution effect X1X3 that results by allowing the consumer to be able to purchase the old bundle is greater than the substitution effect X1X2 that results by holding the utility constant.
In the second figure, the substitution effect X1X2 that results by holding the utility constant is greater than the substitution effect X1X3 that results by allowing the consumer to be able to purchase the old bundle.