Answer to Question #319305 in Microeconomics for Ishaq

Question

With the aid of appropriate diagram examine the income and substitution effect for an increase in price of good x.

Answer 1

The income effect is the change in consumer spending as a result of a change in income. This means that if a consumer's income rises, they will spend more, and if their income falls, they will spend less.

On the other hand, substitution effect is when a consumer's financial situation changes, he or she may substitute cheaper or moderately priced things for more expensive ones. A favorable return on investment or other monetary rewards, for example, may persuade a consumer to upgrade from an older model of a costly item to a newer one.

These two phenomena can be well illustrated with the graph below,

Suppose that the price of good X falls (price of Y remaining unchan­ged) so that the budget line now shifts to PL’. The purchasing power of the consumer increases and therefore purchases more of good x. An increase in the price of X will have a negative effect on the budget line.