Question

State legislators recognize that a change in the price of school supplies has both a substitution effect and an income effect. How are the substitution effect and income effect different from each other? If school supplies are an inferior good and the price of school supplies increases, how does this impact the substitution effect and the income effect? What are the potential implications for the total effect of the price increase?

Answer 1

The substitution effect explains the consumer will shift from the commodity whose relative price have increased to the commodity whose relative price have reduced due to the price change of a particular commodity. E.g. if price of commodity_X have increased then consumer will preffer to decrease the consumption of good_X.

The income effect shows that how consumer's purchasing power have changed due to the change in the price of a particular commodity. E.g. if commodity X price have increased , then now we can say that consumer purchasing power have reduced because his budget set have contracted, and due to this change in the budget set he will reduce his consumption of both of the goods

For an inferior commodity the income effect is such that , if consumer's purchasing power increase then he will reduce the consumption of the inferior commodity. And substition effect is still the same as in the case of normal good.

If the price of school supplies increase (where school supply is an inferior commodity) then due to the substitution effect the demand for school supplies will decrese (as its relative price have increased). And now due to this increased price , his purchasing power will reduce , hence the consumption for uniform supply will increase.

The net price effect would depend on the relative magnitude of the income & substitution effect. If income effect > substition effect => demand of uniform supply increase. And if substitution effect > income effect , then demand for uniform supplies decrease.