University:
California State University, Northridge
Course:
ACCT 505 | Financial and Managerial Accounting in Industry
Academic year:

2024
Views:

487

Pages:

1
Author:

Alissa Acosta

This graph shows the substitution effect and income effect of a price increase for a normal good. C A B U1 sub B3 inc B2 total x2 x3 B1 U2 x1 The price of x increases causing the budget line to shift from B1 to B2. The consumer changes his consumption from the bundle of x and y represented by point A to the bundle represented by point B. The movement from A to B represents the total effect of the price change. Consumption of x goes down from x1 to x2 for two reasons. The substitution effect occurs because x is now more expensive relative to y (B2 is steeper than B1). The income effect of the price change occurs because real income (I/Px) has decreased. B is on a lower indifference curve than A. The total effect is the substitution effect plus the income effect. To separate the substitution effect from the total effect, first draw a new budget line, B3. B3 is parallel to B2 because it represents the higher price for x. It must be tangent to the original indifference curve U1. In the graph above this is point C. Point C shows us how much x the consumer would buy if the price of x were increased and at the same time he was given more income so that he was no worse off than he was before the price went up. The movement from A to C is the substitution effect. The income effect is what is left when the substitution effect (A to C) is subtracted from the total effect (A to B), which is B to C in the graph above. X is a normal good because when then the budget line shifts from B3 to B2 (income decreases), consumption of X goes down from x3 to x2.