Question

Explain the rule for determining the sign of the income effect of a change in px on demand for x. Make sure to consider both the case in which the individual is a net buyer of x and in which they are a net seller of x.

Answer 1

The income effect: It is the change in demand for a good or service caused by a change in a consumer's purchasing power resulting from a change in real income. This may happen if price of goods that consumer buys decreases. So consumer will be left with more income.

If an individual is a buyer:

If the good is a normal good then increase in income will increase its demand. Example- A brand new car. Hence there will be positive sign. Income elasticty of demand will be positive.

Income elasticity of demand (Yed) : % change in quantity demanded/% change in income

In this case, increase in income will increase demand.

If the good is a inferior good then increase in income will decrease its demand. Example- A second hand car.

In this case, increase in income will decrease demand. Hence negative sign.

If an individual is a seller:

If price increases then seller will supply more good. Hence, it will have a positive sign due to law of supply. However, if a price increase is due to change in costs of raw material then sellers will decrease supply and it will have a negative sign.