Evaluating the Substitution Effect.
m = $120,
p1 = $3 per unit
Demand
The demand for milk is (10 + 120/(10*3) = 14 units per week
If the prices falls to p2 = $2 per unit. The demand for milk is;
10 + 120/(10*2) = 16 units per week
Substitution Effect = Incomes required to keep the purchasing power consistent.
The substitution effect is therefore;
Income Effect.
This refers to the change demand caused by a shift.
Constant prices (p1',m')
The income effect is therefore negative for normal goods and positive for inferior goods. In a nutshell, the rise in prices reduces the income which in turn reduces the demand for the commodities.
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