4(a) Income effect is the effect of a change in price of a quantity demanded arising from the consumer becoming better

or worse off as a result of the price change while substitution effect is the effect of a change in price on quantity demanded arising from the consumer switching to or from alternative products. (Sloman, 2007)
A Normal Good

Quantity of Snickers Good Y

A

P R Q

I2 I1

0 0 B

Quantity Good X

of Coke

Figure 4.a When Coke is normal good

In the figure 4.a, the original budget constraint is AB and point P represents the initial consumption bundle. When price of Coke falls, the budget constraint will rotate to AC as real income increases. The consumer can now access indifference curve I2 instead of I1, increasing his utility. His new consumption bundle is at point R. Consumer has more real income and able to buy more Coke( Income effect). Coke is relatively cheaper than Snickers and consumer desire to buy more(Substitution effect).Overall, the fall in price of Coke results consumption for Snickers decreases but increase consumption of Coke.

(b)

An Inferior Good

Quantity of Snickers
Good Y A

R P Q I2

I1

0 0 B

Quantity of Coke
C C Good X

Figure 4.b When Coke is inferior good and substitution effect dominates

In figure 4.b shows when substitution dominates, point P represents the initial consumption bundle. A fall in the relative price of Coke causes budget constraint AB to rotate to AC. The new bundle consumed is represented by point R which lies on the higher indifference curve I2.

In this case, the income effect is negative as richer consumer want to buy more Snickers, but not large enough to outweigh the positive substitution effect(consumer buy more of cheaper Coke compared to Snickers). Overall, the fall in price of Coke causes increase in consumption.

A Giffen Good

Quantity Good of Y Snickers

A

I2 P Q

I1

0 0 B

Quantity of Coke Good X

Figure 4.c When Coke is inferior good and income effect dominates

In the figure 4.c shows when income dominates. The original consumption bundle is represented by Point P. The relative price of Coke falls and a new consumption bundle is selected at point R, on the higher indifference curve I2. The positive substitution effect (consumer buy more of cheaper Coke compared to Snickers) but not large enough to outweigh negative income as richer consumer want to buy more Snickers. Therefore, as the price of Coke falls, consumption for Coke falls (from P to R) and the demand curve is therefore upward sloping. Word Count: 337