Answer to Question #216640 in Microeconomics for Zeki

Question

Assuming the income of the consumer to be constant, what will be the effect of a decline in price
of both commodity X and commodity Y by the same proportion? Explain your answer with the
help of graph(s).

Answer 1

Microeconomics

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Introduction

The change in consumption of any commodities usually occurs due to changes in the relative prices of the commodities and not due to a change in the income of the consumer of the commodities (Varian, 2018). This can be referred to as the substitution effect. Substitution effect states that when the price of a good decreases, consumers tend to substitute it with goods that are relatively cheaper from goods that are expensive. Much depends on whether the products are close substitutes.

Graphical illustration of substitution effect in a decline in price of both Commodity  X and Commodity Y

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The initial price ratio I which is the price of commodity Y and is relative to commodity X is referred to as the relative price of commodity Y in terms of commodity X. The consumer initially consumes both commodities X and Y at point B and consumes X1 units of X and Y1 units of Y. Consider now the effect of a fall in the price of commodity X from P0 to P1 (Leung et al., 2017). Due to a change in price we see that, commodity Y is now relatively more expensive in terms of commodity X, and commodity X is now relatively less expensive in terms of commodity Y. It is clear that substitution effect measures the change in consumption such that the consumer’s level of utility does not change. Therefore, substitution effect can be thought of as a movement along the same indifference curve (Thaver, 2018). Substitution effect purely results in a change in consumption from point B to point C. Consumption of commodity X increases from X1 to X2, and the consumption of commodity Y decreases from Y1 to Y2 (Wolcowitz, 2018). In conclusion points B and C give the consumer the same level of utility as they lie on the same indifference curve.

References

Leung, A., McGregor, M., & Chesney, J. (2017). Income and Substitution Effects: Graphical Analysis for Intermediate Microeconomics. Journal for Economic Educators, 14(1), 97-107.

Thaver, R. L. (2018). Integrating the Output and Substitution Effects of Production into the Intermediate Microeconomics Textbook. Business Education & Accreditation, 5(1), 81-90.

Varian, H. R. (2018). Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.

Wolcowitz, J. (2018). Linking the substitution and output effects of production to profit maximization in the intermediate microeconomics course. Business Education & Accreditation, 6(1), 13-22.