Answer to Question #125591 in Microeconomics for Fawad Hassan

Question

Suppose there are 2 goods X (inferior good) and Y (normal good). Assume there is increase in price of good X, draw and explain the decomposition of price effect (of increased price of inferior good) in substitution and income effect.

Answer 1

When income rises may lead to decrease in demand of a good this is referred to as an inferior good.

The decomposition in price effect and the income effect is illustrated by the following graph.

The difference between the amount of good consumed in A and D is the substitution effect while the difference between the good consumed in B and D is the income effect.