Answer to Question #153124 in Microeconomics for Salah yahye

Question

3.With the help of a well labeled diagram;
a)Show and clearly explain the substitution and income effect of price increase in the case of a normal good
b)Explain how the substitution effects explain the law of demand

Answer 1

With an increase in the price for a normal product ", with an increase in price, the optimal position of the consumer shifts to the lower indifference curve U1U1. The overall effect of an increase in the price of good X is a decrease in its consumption from OX1 to OX2 (X2X1). The substitution effect is the difference between OX1 and OX3 (X3X1), the income effect is the difference between OX3 and OX2 (X2X3). The substitution effect is determined by the movement along the same indifference curve, and the income effect is determined by the transition from one curve to another. The income effect enhances the effect of the substitution effect, increasing consumption of good X when its price decreases,

and reducing consumption when prices increase.

The substitution effect is a change in demand (consumption) caused by a change in relative prices. When the price of a product, for example, falls, other products become relatively more expensive. The consumer then has an incentive to increase the consumption of the given good at the expense of others.

The overall effect of a price change is the sum of two effects:

Overall effect = Substitution effect + income effect.