Answer to Question #164737 in Microeconomics for Anushka patel

Question

Dissect price effect into income and substitution effect for normal good

Answer 1

Solution:

The income effect is the change in the consumption of goods based on income. As such, consumers will normally spend more if they experience an increase in income, and they may spend less if their income drops.

The substitution effect occurs when a consumer replaces cheaper or moderately priced with ones that are more expensive if they experience an increase in income, but should they experience a decrease in income, they may replace expensive items with relatively cheaper ones.

A normal good is any good that experiences an increase in its demand due to an increase in consumer income.  That is, if there is an increase in wages, demand for normal goods increases, but when the wages decrease, the demand for normal goods decreases.

The income effect is positive for normal goods. When the price of a normal good falls and there is an increase in the purchasing power, the 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. The reduction in price increases the consumer’s ability to purchase more goods, increasing its demand. The substitution effect contributes to an increase in the quantity demanded since consumers will substitute more of the goods for other goods.

On the other hand, if the price for normal goods increases and the income remains the same, the substitution effect will kick in and reduce the quantity demanded of the good, since consumers will prefer cheaper alternatives. Due to the income effect, the demand for normal goods will fall.