Suppose a consumer has preferences between two goods that are perfect substitutes. Can you change prices in such a way that the entire demand response is due to the income effect?
Answers
Yes.
Understand first:
1. Normally, when we reduce price while talking about perfect substitutes, we are reducing the price of the expensive good. So if you were on the y axis in the graph of perf subs, and price of good x, which was realtively expensive earlier, has now reduced. So you will come down to choosing all x on x axis.
2. Income effect refers to the change in real income or purchasing power due to a change in price. So if price falls, your real income essentially increases.
Answer:
If we decrease the price of the already inexpensive good, lower. Then the real income of the consumer increases. Due to this he buys of the inexpensive good.
So this change in demand, where he now buys more of the inexpensive good, has been caused due to increase in real income due to fall in price of the already inexpensive good.
Hence, if we reduce the price of the already inexpensive good further down, the entire demand response is due to income effect.