Suppose the demand curve for bus travel is downward sloping, and the income elasticity of demand for bus travel is negative.
(i) Design an indifference curve-budget line diagram showing the substitution and income effects created when the price of bus travel falls. In your diagram, place bus travel on the horizontal axis and all other goods on the vertical axis.
(ii) How you can tell from your diagram that the income elasticity of demand for bus travel is negative? Explain.
(i) Bus travel is an inferior good, so the substitution and income effects must be in opposite directions. Since the demand curve for bus travel is downward sloping, the substitution effect must be larger than the income effect. This situation is shown in the accompanying diagram, where point A is the initial optimum and point B is the final optimum.
(ii) Consider points C and B in the diagram. The parallel shift in the budget line shows a rise in income, but quantity demanded is falling from C to B. Therefore, income and quantity demanded are moving in opposite directions, so bus travel is an inferior good. The income elasticity of demand for inferior goods is negative.
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