Question

Q1 - Why is price inversely related to quantity demanded? ( substitution effect and or income effect.)

Answer 1

There are three reasons why the price is inversely related to quantity demanded:

1. Substitution effect - As the price of a good X increases, people substitute that good for another good Y which acts as its substitute. Thus price increase, decrease the quantity demanded of a good.

2. Income effect - As the prices of a good increase, the ability to consume that good given the income level decreases. This means as the good gets costlier, its demand decreases as it becomes difficult to afford given the income of the consumer.

3. Diminishing marginal utility - The law of diminishing marginal utility states that as a person consumes a good, the want of consuming more keeps on decreasing. This means that as consumption increases, the satisfaction from an extra unit of the good consumed falls. Given this, the consumer will only increase his consumption if the prices fall.

All the reasons above show that the price and quantity demanded to have a negative relationship.