Answer to Question #232915 in Microeconomics for Binaya

Question

Explain graphically how price effect is decomposed into income effect and substitution
effect for normal good. Also derive Engel curve for a commodity measured on horizontal
axis.

Answer 1

a)

Decomposition of price effect into income effect and substitution effect means that the total price effect can be divided into two components as income effect and substitution effect.

The substitution and income effects work in the same direction for normal good and the final price effect is then positive. The consumer tends to increase consumption with fall in price.

b)

For an individual consumer, the Engel curve is derived from the Income Consumption Curve (ICC). Every point on the ICC depicts three items : a consumers income, his demand for good X and his demand for good Y. 

This can be shown by the following diagram :

In the given graph, E1 depicts a combination of money income M1 and L1 i.e. the income which is represented by the budget line L1M1, the demand for good x is depicted by x1 and the demand for good y is depicted by y1.

In the same way, E2 and E3 depict the other budget lines and demand for good x and y . 

A point on the ICC gives a set of combinations of income and the demand of good X, i.e. L1, M1, x1.

Therefore, if the set of combinations are plotted, we get the Engel curve for good X, which is OP. A consumer purchases more of a good a his money income increases, while the prices remain constant.