Question

v1. Define the incorrect effect. What variables do we hold constant in order to isolate the income effect? 2. Define the substitution effect. How does it relate to income effect? 3. How do income and substitution effects differ between normal and inferior goods? 4. How does the market demand relate to individual demand curves?

Answer 1

1. The income effect is the effect on real income when price changes - it can be positive or negative. As price falls, and assuming nominal income is constant, the same nominal income can buy more of the good - hence demand for this (and other goods) is likely to rise. The income effect expresses the impact of increased purchasing power on consumption. The positive income effect measures changes in consumer's optimal consumption combination caused by changes in her/his income, prices of goods X and Y, which are normal goods, remaining unchanged

2. The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. if price of A goes up, people shift to its substitute B. The income effect expresses the impact of increased purchasing power on consumption, while the substitution effect describes how consumption is impacted by changing relative income and prices.

3. n case of inferior goods the income effect will work in opposite direction to the substitution effect. When price of an inferior good falls, its negative income effect will tend to reduce the quantity purchased, while the substitution effect will tend to increase the quantity purchased.

For normal goods, the income effect is positive. Therefore, when price of a normal good falls and results in increase in the purchasing power, income effect will act in the same direction as the substitution effect, that is, both will work towards increasing the quantity demanded of the good whose price has fallen

4. market demand is nothing but a sum total of individual demands only.