Question

You are a consumer who consumes goods X (education) and goods Y (recreation), where the price of good X is PX and the price of Y is Py. Your income that can be allocated to purchase these two items is M.

Questions
a. What happens if the price of education rises? Describe the substitution effect and the income effect.
b. Derive the demand curve for education.

Answer 1

Given,

Good X = Education, Price = P(X)

Good Y = Recreation, Price = P(Y)

Income = M

Assumption: Education and Recreation are normal goods ( not given otherwise)

a. If the price of education rises, consumers will not be able to allocate a similar amount of income to education as they were before the rise in price. This will make education relatively expensive and recreation relatively cheaper.
Substitution Effect: As a result of a rise in price and education becoming expensive, consumers are likely to shift a larger share of their income towards recreation as it has become cheaper. (Assuming the preference for both the goods is similar since they are normal goods). Hence, due to the rise in price for education a consumer will substitute Good X (education) for more quantities of Good Y ( recreation).
Income Effect: Income effect is the change in demand for a good or service due to change in consumer's real income. In the above question, due to the increase in price of education, a consumer will not be able to invest as much in education as he used to due to limited income (M). This will make the consumer relatively poorer, and decrease the real income. As a result, in order to obtain maximum satisfaction, consumers will decrease the quantity demanded of good X ( education) in response to the fall in real income and rise in prices of education.