Answer to Question #222337 in Microeconomics for Zeki

Question

Explain the substitution and income effects of a price rise for a normal good using a diagram

Answer 1

When the price of a normal good rises the optimal position of the consumer shifts to the lower indifference curve U1U1. This leads to a decreased consumption from X1 to X2. The substitution effect is the difference between X1 and X3 and the income effect is the difference between X3 and X2. The income effect enhances the effect of the substitution effect, increasing consumption of good X when its price decreases, and reducing consumption when prices increase. The substitution effect is a change in demand (consumption) caused by a change in relative prices.