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Assuming price falls for a normal good namely Good X

explain diagram

as price falls for Good X, the budget line for Good X pivots inwards from B1 to B2.

Explain substitution effect

New budget line B3 is parallel to B2 and tangent to IC1 at B1

B3 represents the new price ratio —> new price of Good X

Being tangent to IC1 —> consumer able to obtain the same utility as before —> no loss in real income —> income effect is excluded

Movement from point 1 to point 2 —> due to changes in price of Good X and Good Y

Therefore, movement from Q1 to Q2 —> substitution effect

Explain income effect

Budget line shift to B2 —> consumers consume at higher indifference curve IC2

Real income rises

Movement from Q2 to Q3 —> income effect

-Substitution effect of point 1 to point 2 —> positive

Income effect of point 2 to point 3—> negative

Therefore, total demand rises as shown —> price fall from p to p1 —> qty d rises from q to q1

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Assuming good X being inferior goods now

When price of gd X falls -> budget line pivot outwards to B2

Substitution effect;

Imaginary budget line B3 is drawn parallel to B2 but tangent to indifference curve

Budget ine B3 represents new price ratio that is lower price of good X

If price of gd X falls, substitution effect will be positive as consumers will consumer more of gd X relative to gd Y since now gd X is cheaper

Movement from point 1 to point 2 is due to change in relative prices of gd X and gd Y

Income effect;

The rise in real income (due to the fall in price of X) will lead in the consumption of gd X since a rise in real income will result in lesser purchase of inferior gds

Hence from point 3 to 2, income effect decreases the quantity demanded of gd X from Q2 to Q3

Referring back to the diagram, it can be seen that there’s an overall rise in quantity demand for inferior goods from Q to Q1 as the rise in substitution effect is greater than the fall in income effect.

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Indifference curve analysis:

Shows how a consumer allocates their income to purchase combinations of two goods that provide the same level of utility (satisfaction)

All points on the indifference curve give the same utility

Budget line:

Shows all combinations of two goods that a consumer can afford given their income and the prices of goods.

When a consumer max utility, eqb occurs where budget line is tangent to indifference curve

Normal good:

QtyD increases as income increases

Eg. clothing, cars, etc

Inferior good:

QtyD decreases as income increases

Eg. instant noodles, poor quality rice

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Other than indifference curve analysis can be used to derive the demand curve for a normal good and the demand curve for an inferior good, it can also be used to derived the demand curve for giffen goods

However there are some limitations that should be taken into consideration when using the indifference curve analysis to derive demand curve;

Consumers are able to choose more than one goods

Consumers may not be willing to accept any combination of the two goods represent by an indifference curve

Consumers may not always act rational