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Income and Substitution Effect

In: Business and Management

Submitted By pmorny
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Income and substitution effect of a change in price.
When a good changes in price, the quantity demanded will be changed by the sum of the substitution and income effects.
Substitution effect: When the price of a good rises, consumers will buy less and less of that good and more of other goods because it is now relatively more expensive than the price of other goods. If the price of a good falls, consumers will buy more of the good and less of others. These changes in quantity demanded sole due to the relative changes in prices are known as the substitution effect of a price change.
Income effect: if the price of a good rises, the real income of consumers will fall, as they will not be able to buy the same baskets of goods as before. Consumers can react to the change in one of two ways; if the good is a normal good they will buy less but if it is an inferior good, they will buy more. These changes in quantity demanded caused by a change in real income is known as the income effect of a price change.
For a normal good, the income and substitution effect work in the same direction. A rise in price leads to a fall in quantity demanded because the relative price of the good has risen. It also leads to a fall in quantity demanded because there is a reduction in real income. So an increase in price leads to a decrease in quantity demanded and vice versa.
For an inferior good, the income and substitution effect work in the opposite directions, an increase in price will lead to a fall in quantity demanded because the relative price of the good has risen. But it leads to a rise in quantity demanded because consumer’s real incomes have fallen. However the substitution effect outweighs the income effect because overall it is still true for an inferior good that a rise in price leads to an overall fall in quantity demanded.
A giffen good is a special sort of inferior…...

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