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IAI Actuarial Core Principles · Business Economics · Consumer demand and behaviour

Ramesh spends all his income on food and travel. Food becomes cheaper. Using the Hicksian approach, the substitution effect is measured by moving along:

In the Hicksian method the substitution effect keeps utility constant, so it is the movement along the original indifference curve to the point where its slope equals the new price ratio. The remaining movement to the final equilibrium is the income effect.

  1. Athe original indifference curve to the point where the slope equals the new price ratioCorrect
  2. Bthe new budget line to the original consumption bundle
  3. Cthe original budget line to the new indifference curve
  4. Dthe new indifference curve to the point where the slope equals the old price ratio
  5. the income expansion path to the new equilibrium

Explanation

Hicks holds real income constant by keeping utility fixed. The substitution effect is the movement along the original indifference curve to the tangency with a hypothetical budget line parallel to the new one. The remaining move to the final bundle is the income effect.

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