Question

7. When the price of Coke rises, we see that consumers shift to purchase more Pepsi which is still cheaper. This statement describes:

    A)    An inferior good.    

    B)    The rationing function of prices.

    C)    The substitution effect.

     D)    The income effect.

Answer 1

The total price effect is composed of two components namely substitution effect and income effect.

Substitution effect

when the price of a commodity(coke) rises then that commodity becomes relatively expensive in comparision to the other commodity(pepsi). In other words the other commodity(pepsi) becomes relatively cheaper in comparision to the commodity whose price has risen(coke).As a result the consumer will decrease the consumption of commodity whose price has risen(coke) and substitute it with the relatively cheaper commodity(pepsi) i.e the demand for the relatively cheaper commodity will increase. This is called substitution effect.

Income effect

when the price of a commodity rises then the real income i.e the purchasing power of consumer falls. As a result the demand for both the commodities will change. The demand will increase if the commodity is normal good and decrease if the commodity is inferior good. This is called income effect.

So based on the above definitions the correct answer is option (c).