Answer to Question #27008 in Microeconomics for mohd moin

Question

Price effect is the combination of incom and substitution effects. Discuss.?

Answer 1

The price effect is viewed as a combination of income and substitution effects. The substitution effect always works in one direction. A consumer is always induced to buy more units of a cheaper good. Income effect on the other hand could be positive, negative or zero in case of normal, inferior (including Giffen goods) or neutral goods respectively.

Therefore, the price effect, as the final outcome of the substitution and income effects, depends on their relative direction and magnitude.
The substitution and income effects work in the same direction when good X is a normal good. The final price effect is then positive. The consumer tends to increase consumption of Good X with fall in its price.

When good X is an inferior good, then the substitution and income effects work in opposite directions. When price of good X (Px)falls, the consumer tends to increase consumption of good X as a result of substitution effect. However, income effect here is negative. The price effect then depends on relative magnitude of the two effects. The final price effect is positive for inferior goods, as change in the consumption of good X as a result of the substitution effect is greater than the income effect.

When good X is a Giffen good then also substitution and income effects work in opposite directions. When price of good X (Px)falls, the consumer tends to increase consumption of good X as a result of substitution effect. However, income effect here is negative. Further, the magnitude of change in units of good X on account of the substitution effect is less than the income effect. The price effect, the final outcome, is therefore negative.