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When you are only told in the question that the price level of the inferior good decreases, how can you draw the indifference curve accurately? The size of Substitution effect depends on the curviness of the curve. Thus when I draw my diagram, it is not matching with the one in the textbook. enter image description here When do you prevent this when no figures about the exact consumption is given? Thanks


1 Answer 1


Could you clarify what your your question is? If Ramen is inferior then an increase in wealth (parallel shift of the budget line) should cause the consumption of ramen to go down. Hence $B$ should be to the left of $A'$. Then income effect is the distance on the x-axis from $A'$ to $B$.

(Edit in response to the comment)

Let me try.

The slope of the budget line is related to ratio of prices. So $A'$ is the point of tangency of between the old indifference function and a budget line with a new ratio of prices. Essentially what it is saying is what would be your basket if the price of ramen was reduced but some of your money was taken away, so that you are no better and no worse off. The change from A to A' is pure substitution effect.

Then, since your money was not actually taken away from you, you have to consider income effect. This is achieved by shifting the dased line upwards. So A -> A' is substitution effect. A' -> B is income effect.

Direction of substitution effect is always the same. Higher relative price means less consumption. Direction of income effect depends on the type of goods.

  • $\begingroup$ Sorry for the confusion, I made a mistake of stating the wrong income effect. My question is how do you decide where A' lies? I always have trouble with deciding which sides of B A' should be at, could you explain a bit more about this? I don't actually understand what A' is showing. All I know is that this the the point of tangency and that this is a hypothetical point... Thanks a lot $\endgroup$
    – D.I.N
    May 6, 2018 at 16:06
  • $\begingroup$ I added the explanation. If you are satisfied with the answer consider accepting ir. $\endgroup$
    – ElChorro
    May 6, 2018 at 17:16

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