Question

What is the substitution effect with respect to a price change for a product? What is the income effect? Show with an indifference curve diagram why the substitution effect is always negative while the income effect may be positive, negative, or even in some cases neutral (zero)

Answer 1

Income and substitution effect In case of normal goods 0 at a pouz e tus suppose Price of x' fulls, then consumer will purchase more of goods and the rotatis budget line outward Now due we draw a hypothetical budget line which is parallel tot the new budget line and tangent to the w all initial Indifference curve. at a point B. This AB → Substitution effect and B2 F Income effect tue en come extent is positive, thus when price of x faces quantity demanded of good x . 7 imoreas D ISANT R . - IC2 Good y U Income effect بعد مل اه ، - نن تر از آنان از پاره د I Substifiction effect vo V ET Z200 A B Zastoss Svigo2.c4 weit Good X to the

ما مودم بلدمار از را LONTON ) 220) me As a result of fall in price of X, budget 20 line new rotates outward equillibrium point and and R and reach to a reach . oron sus Also, we draw the hypothetical budget line wo. which is tangent to Initial indiff crence Cave which is tangent tort at point. io. Sou wat 0 cu evil trend was vond Inandabre en در ) 2 دانه ی ه با وانت بار و ل ترامنا N Dries soodne E sa a Justice si de suas need No sabato sera X zo ICL E NABDICOM ICI A 2 . substitution effect & Hue encome effect ŹB is negative 7 because as price of good x falls, a lity demanded of good x will increasca or decrease it negative in come eftact outweigh positive Sulis is less than or greater than positive substitution effect .

Now encome effect is zero for goods, There is no sucome effect Substitution effect . neutral only - ICL A BQSX Hue we get only substitution effect = AB
Ans. If we plot good X on the horizontal axis and Y on the vertical axis, due to an increase in the price of good Y, people will choose more of good X where X and Y are substitutes. It measures how people choose the alternative goods when price of other good increases.

Income effect- Income effect measures how income of a consumer changes when price of a good changes. For example if price of a good increases, then same amount of income will gives the consumer lesser amount of that good. It also shows the negative relationship between price and quantity demanded of a product.

Now total effect as a result of a price change can be decomposed into substitution effect and income effect.

Now the substitution effect is always negative because when a price of Y increases consumers will always purchase good X as is became cheaper. Thus whatever may be the nature of the good, consumers will always substitute expensive good with cheaper good.

while income effect is positive in case of normal goods, negative in case of inferior goods and zero in case of neutral goods.