On a consumer's indifference curve and budget constraint graph, between which two points does the income effect outweigh the substitution effect when the price of a good decreases?

• A. Between the original equilibrium and the compensated equilibrium (holding utility constant)
• B. Between the original equilibrium and the new equilibrium after the price decrease
• C. Between the compensated equilibrium and the new equilibrium after the price decrease
• D. Between any two points along the same indifference curve

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the concepts of substitution effect and income effect when the price of a good decreases. The substitution effect shows how the consumer changes consumption by substituting towards the relatively cheaper good, holding utility constant. The income effect shows how the consumer changes consumption due to the increase in real purchasing power from the price decrease.
2. Step 2: Identify the key points on the graph: the original equilibrium (before the price change), the compensated equilibrium (after adjusting income to keep utility constant), and the new equilibrium (after the price decrease and income adjustment).
3. Step 3: Recognize that the substitution effect is represented by the movement from the original equilibrium to the compensated equilibrium, since utility is held constant and only relative prices change.
4. Step 4: Understand that the income effect is represented by the movement from the compensated equilibrium to the new equilibrium, reflecting the change in consumption due to increased real income after the price decrease.
5. Step 5: Conclude that the income effect outweighs the substitution effect if the change in consumption between the compensated equilibrium and the new equilibrium is larger than the change between the original and compensated equilibria. Therefore, the income effect dominates between the compensated equilibrium and the new equilibrium after the price decrease.