Question

In order to fully understand a consumer’s decision-making, we need to take into account both the preferences and desires of the particular consumer but also the Budget or Income of the consumer AND the Price, P of each of the two goods in our model. If there are changes to either the consumer’s Budget or Income, OR the the Price, P of either good, we can separate the impact of the change through the Substitution and Income effects that occur.

i.    What would be the change if any, from EACH of the “substitution or income effect” (1) if the Price of good A, P_Aremains constant while the Price of good B, P_B decreases and Why? AND, (2) If the Prices of the two goods remain constant BUT the Budget or Income of the consumer were to rise or increase and why?

Answer 1

The price effect is the sum total of the income effect and the substitution 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. While 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 and vice versa. It describes how consumption is impacted by changing relative income and prices.

1) If the price if good A, PA remains constant while the price of good B, PB decreases. In this case the good B becomes relatively cheaper than good A, so the consumer may substitute good A with good B(all or some part). So in the case the substitution effect is higher than the income effect.

2)  If the Prices of the two goods remain constant but the Budget or Income of the consumer were to rise or increase, in this case since there is increase in the monetary income of the consumer so he can buy more of both goods A and B and there may not be any substitution between the goods A and B. So here income effect is higher (larger) than the substitution effect.