Question

what are the economic meanings of the of subsitution and income effect? and how can you tell if a good is a normal good or inferior or giffen good?

Answer 1

Answer:

Substitution Effect-It measures the increase in the quantity demanded of a good when the its price falls resulting only from the relative price decline and independent of the change in real income. Thus substitution effect describes how consumption is impacted by changing relative income and prices.

Income Effect- It measures the increase in the quantity purchased of a good resulting only from the increase in the real income that accompanies a price decline. Thus income effect is the change in consumption of goods based on income. This means consumers will generally spend more if they experience an increase in income, and they may spend less if their income drops. But this effect doesn't dictate what kind of goods consumers will buy.

Normal Goods-A good is normal if the substitution and income effects of a price decline are both positive and reinforce each other in leading to a greater quantity purchased i.e. consumption.

Inferior Goods-A good is inferior if the positive substitution is larger than negative income effect of a price decline. Here substitution effect is positive and income effect is negative for inferior goods because they move in opposite directions.

Giffen Goods-An inferior good if the positive substitution is smaller than negative income effect of a price decline.