Answer to Question #223446 in Microeconomics for Melsy

Question

Explain clearly with the aid of a graph the income and substitution effect of a price fall for a normal good

Answer 1

As people's wages and spending power rise, so does their demand for everyday things. A normal good is defined as having a positive income elasticity of demand coefficient that is less than one. For ordinary goods, both the income and substitution effects work in the same direction; a decrease in the relative price of the goodwill result in an increase in quantity demanded, both because the good is now cheaper than substitute goods and because the lower price means that consumers have more total purchasing power and can increase their overall consumption. When actual earnings rise, consumer demand for inferior products falls, and vice versa. Demand for a good rise as society's economy improves when it has more expensive substitutes. For inferior products, the income elasticity of demand is negative, and the income and substitution effects work in opposing directions. Consumers will prefer to buy alternative replacement items rather than an inferior commodity due to their lower real income. They will also want to consume fewer of the other common goods. Products that are perceived to be of lower quality, such as generic bologna or coarse, scratchy toilet paper, may get the job done for folks on a tight budget. Consumers want a higher-quality product, but they can only buy it if they have a greater income.

Given the prices of two things and his income represented by the budget line PL1, the consumer will be in equilibrium at Q on the indifference curve IC1. Assume that the price of X decreases, the price of Y remains unchanged, and his cash income remains unchanged, and the budget line now becomes PL2. At a position on the new budget line PL2, the customer will be in balance. If the equilibrium point on PL2 is to the right of Q, as shown in the figure above at R, the customer will purchase more good X than at Q. It can now be shown that, for normal items, the new equilibrium point on budget line PL2 will result in an increase in the amount requested of the good X as its price decreases. The direction and magnitude of the change in necessary quantity as a result of a decrease in the price of an item are governed by the direction and intensity of the income effect on the one hand, and the substitution effect on the other. When the price of an item lowers, the income impact is positive, and it will work to increase the amount requested of that commodity. The substitution effect, which is always negative and acts to increase demand for an item when its price falls and decreases the demand for a good when its price increases.