Question

A: What is the difference between the income and substitution effects of a price change?

B: What do economists mean by utility and marginal utility?

C: What does an elasticity of demand measure?

D: How does the Principle of Diminishing marginal Utility relate to the law of Demand?

Answer 1

A. Income Effect vs. Substitution Effect: An Overview

The income effect expresses the impact of increased purchasing power on consumption, while the substitution effect describes how consumption is impacted by changing relative income and prices. These economics concepts express changes in the market and how they impact consumption patterns for consumer goods and services.

Different goods and services experience these changes in different ways. Some products, called inferior goods, generally decrease in consumption whenever incomes increase. Consumer spending and consumption of normal goods typically increases with higher purchasing power, which is in contrast with inferior goods.

Income Effect
The income effect is the change in consumption of goods based on income. This means consumers will generally spend more if they experience an increase in income, and they may spend less if their income drops. But the effect doesn't dictate what kind of goods consumers will buy. In fact, they may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities, depending on their circumstances and preferences.

The income effect can be both direct or indirect. When a consumer chooses to make changes to the way he or she spends because of a change in income, the income effect is said to be direct. For example, a consumer may choose to spend less on clothing because his income has dropped. An income effect becomes indirect when a consumer is faced with making buying choices because of factors not related to her income. For instance, food prices may go up leaving the consumer with less income to spend on other items. This may force her to cut back on dining out, resulting in an indirect income effect.

The marginal propensity to consume explains how consumers spend based on income. It is a concept based on the balance between the spending and saving habits of consumers. Marginal propensity to consume is included in a larger theory of macroeconomics known as Keynesian economics. The theory draws comparisons between production, individual income, and the tendency to spend more of it.

Substitution Effect
The substitution may occur when a consumer replaces cheaper or moderately priced items with ones that are more expensive when a change in finances occurs. For example, a good return on an investment or other monetary gains may prompt a consumer to replace the older model of an expensive item for a newer one.

The inverse is true when incomes decrease. Substitution in the direction of buying lower-priced items has a generally negative consequence on retailers because it means lower profits. It also means fewer options for the consumer.

While the substitution effect changes consumption patterns in favor of the more affordable alternative, even a modest reduction in price may make a more expensive product more attractive to consumers. For instance, if private college tuition is more expensive than public college tuition—and money is a concern—consumers will naturally be attracted to public colleges. But a small decrease in private tuition costs may be enough to motivate more students to begin attending private schools.

The substitution effect is not just limited to consumers. When companies outsource part of their operations, they are using the substitution effect. Using cheaper labor in a different country or by hiring a third-party entity results in a drop in costs. This nets a positive result for the corporation, but a negative effect for the employees who may be replaced.

B. In economics, utility is the satisfaction or benefit derived by consuming a product; thus the marginal utility of a good or service is the change in the utility from an increase in the consumption of that good or service.

C. The price elasticity of demand (PED) measures the change in demand for a good in response to a change in price. The price elasticity of demand (PED) is a measure that captures the responsiveness of a good’s quantity demanded to a change in its price. More specifically, it is the percentage change in quantity demanded in response to a one percent change in price when all other determinants of demand are held constant.

D. In fact, Price in LAW OF DEMAND is nothing but another way of representation of MARGINAL UTILITY!

Economists found it easier to explain if we substitute marginal utility by price. The relationship between the marginal utility and demand ( consumption) can be well explained by substituting marginal utility by price.

For example, as you consume more and more mangoes, the last mango always gives you lesser satisfaction of consumption of that mango, when compared to the satisfaction derived from the LAST BUT ONE mango!

10th mango gives lesser satisfaction than 9th mango! But remember CETERIS PARIBAS operates here also, ALL OTHER CONDITIONS remain constant! It means that all mangoes are same in quality, taste, size, weight, price etc. no mango is inferior to any other mango.

now I turn to the relationship between marginal utility and consumption

AS CONSUMPTION OF MANGOES INCREASES, THE MARGINAL UTILITY (SATISFACTION DERIVED FROM CONSUMPTION) DECREASES! The graph is a curve sloping downwards!

Now substitute consumption of mangoes by DEMAND, and then substitute marginal utility (satisfaction) by PRICE, and now take price on y axis and then take demand on x axis. This is now LAW OF DEMAND which states that as price decreases the demand increases! Remember price is independent variable taken along y axis, while demand is dependent variable taken along x axis.

The relationship between marginal utility (satisfaction derived from the consumption of the additional unit, that is the last mango here) and price is interesting! when you want to buy one kg tomatoes in a vegetable market, you purchase them for $2.0/Kg. now you don't want to buy any more tomatoes. you want to leave. Then the vender says “sir, take one more Kg of tomatoes”. But you refuse, by saying THIS IS ENOUGH for me. no more now. But he persuades you to buy by saying, “ok, take one more kg tomatoes just at $1.8 only “. So, the dissatisfaction of buying more tomatoes (because of law of diminishing marginal utility) is now compensated by reduction in price which is now acting as a motivator against diminishing marginal utility!!

Therefore you are now prompted to demand more quantity of tomatoes, in spite of operation of the law of diminishing marginal utility!!! Thus price is reduced to increase the quantity demanded,ultimately!

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