Question

1. A student asserts in class that the income and substitution effects lead to a decrease in the consumption of a normal good when the price decreases. do you agree with the statement? Explain using examples.

2. Assume that a person only purchases two goods, food and clothing, and has a fixed budget constraint. both goods are normal goods. if the price of food decreases, what will happen to the consumption of food and clothing based on the income effect?

Answer 1

Answer 1

The indifference curve has perfectly explain the Price effect in combination between the income effect and substitution effect as the relationship between both price and qualtity demanded.

A subsitute of any of the product whose price is much cheaper or lower than the good which want to buy always instigate the customer to buy the substitute goods in other words when the price of any substitute good falls the demand of the normal good also falls.

Eg - In the festivals people loves to decorate their home with lights . Suppose a light costs Rs 200 , an individual may refer to its substitute and can buy chinese lights which cost Rs 50 only. Here you can see when the customer finds that when the substitute of that products much lower then normal goods the demand and consumption of that product decreases.

Normally both income and sustitute effect always go in same direction but there are some cases and exception where bothe of them go in opposite or other direction.

The direction of substitution effect is quite certain but the direction of income effect is not certain. For normal goods it is always seen that income effect is always positive.

Now suppose the price of normal goods falls, this will make the income effect move in same direction as substitution effect is moving. The falls in the price of normal goods increases the purchashing power of an individual and this will make rise in the demand and quantity demanded of the product whose price has fallen down.  

Eg-Suppose the price of tea falls down ,the purchasing power of the consumer increases therefore in the case consumer can buy more tea in comparison to the past. Here when the price of tea falls the purchasing power increase and the quantity demanded of tea increases.

Answer 2

In the above question it is given that a person purcahases food and clothing and both of them are normal goods.

When the price of any one of the two products decreases which are normal goods , this ultimately increases the real income of the consumer. When the real income increases this will make a person to spend more on both of the goods. This will also increase the consumption of the other goods because of the income effect.

Explanation- when the price of food decreases this will increase the purchasing power and real income of the consumer. Now he will spend more on both the goods that food and clothing. Hence Due to income effect the consumption of the clothing will also increase.

  Therefore consumption of food and clothing based on the income effect will rise.

i have tried my best to explain you both the answer in the simplified , to the point and in detailed manner. I hope you will like it.

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