Monday, July 8, 2013

Comparative Statics of Consumer Choice

Judy asked:

using well labele diagrams show the total effect,income effect and substitution effect due to a price fall of good x1 assuming that the consumer baskets has only good x1 and x2. The price of good x2 remains constant.

My Response:

I encourage you to watch my video on income and substitution effects.  There the goods are labeled x and y (instead of x1 and x2) and it is for a price increase rather than a price decrease.  I suspect you covered something similar in your class and now your instructor wants you to think through what happens when the price change is in the opposite direction.

From my video in the description there is a link to the spreadsheet.  Go to the tab labeled Income and Substitution Effects. There is a button called Raise Price of Good X.  Push on that and look at the cell next to the button.  It has positive values.  If you type into that cell a negative value, say -15, you will get the graph for a price reduction of Good X.  Note that because this was designed for a price increase, the new budget line doesn't extent all the way to X axis.  It should.

Also, your instructor may feel I'm doing your homework for you and not be happy about it.  So if you pose another question of this sort to Ask The Prof, please also include what you've tried to do in response.  This way I can help you without giving away the answer to the question.