Explain what is meant by income and substitution effects of a price change and discuss why these might be different for different type of goods.

Essay by kingkaisai2University, Master'sD+, May 2006

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There are two types of good- normal good and inferior good that will be discussed. A normal good is affected by income positively. That means as income increased quantity decreases. Note that when it says income, income goes up, it means the real income or the purchasing power of the consumer. An inferior good, however, a good that may in the consumer eyes be the sign of cheapness, inferior quality, consumers will buy less of the product when their purchasing power increases because they can now buy better goods. And an important rule to note here is 1) consumers are rational and 2) consumers want to achieve max. utility from their purchase. 3) consumers prefer buying more to less. The income effect for inferior goods as income increases and quantity decreases( negative relationship) is the result of 2) because buying more to less. The income effect for normal goods can be explained by 3) consumers prefer buying more to less because now with the additional income the consumer will now buy more.

Important to note that real income, increases due to a decrease in price of the product or the increase in actual income ( while the price of good stays the same. That explains the effect of price on the income effect.

For substitution effect, normal goods will have a negative relationship while inferior good will have a positive relationship. The negative relationship as price decreases, quantity of product increases and the quantity of substitute decreases. This is derived from the consumers prefer buying more to less, now that price of a product decrease, consumers can now buy more of it and subsequently will demand less of the substitute. Rationality also plays a major role here, consumers will choose the product with less price. For inferior...