Question

Suppose that your demand curve has a positive slope for good G. Is the income effect smaller or larger than the substitution effect for a price change in good G? Why?

Answer 1

Income effect is larger than substitution effect

Price effect can be decomposed into Income and substitution effect and is given by:

Price effect = Substitution Effect + Income Effect

=>

where = Price effect , = substitution effect and = Income effect.

Now it is given that Demand curve is upward sloping this means as Price increases Demand will also increase.

Hence, = Price effect > 0,

Suppose Price Increases then In or to buy Good G we have to sacrifice more of our other goods or say Income. Hence Rate of substitution increases. Hence because of this demand of G due to substitution effect decreases => = substitution effect < 0

Hence In order to to be greater than 0 , + > 0 and as discussed above < 0

Hence must be greater than 0 and in order to + > 0 , absolute value of > absolute value of .

Hence Because of this Income effect is larger than substitution effect