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SE+_+IE - is the relationship between the amount of x and y...

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To find the substitution effect and the income effect: Step 1) Find the initial basket of goods with initial price level. Let this be xI and yI. Find the amount of utility of the initial basket from the level of x and y. Suppose the amount is U1 (this will be a number as you know precisely the value of x and y). Step 2) Find the final basket with final price level. Let this be xF and yF. You know the final level of utility. Step 3) Find the decomposition basket. To find this, first equate MRS xy = new p x /p y . This will give a relationship between x and y, that
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Unformatted text preview: is the relationship between the amount of x and y consumed at the new price level. Suppose these are x1 and y1. But as the decomposition basket remains on the original/initial utility level, x1*y* must be equal to U1, that x1*y1 = U*. You can solve for the values of x and y for the decomposition basket now. If price of x changes, then the difference between final and decomposition basket of x will give the substitution effect and the difference between the final basket and decomposition basket will give you the income effect....
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