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When analyzing the income and substitution effect, we need to consider the inome change that is necessary to move the the consumer to the required utility level while maintaining the intial prices. This is called the income effect.
The actual level of utility changes along the…
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Download file to see previous pages... It explains how consumers will behave as a result of change in prices (Frank, 2007 pg 66).
Therefore, the compensated demand curve shows the relationship between the price of a good and the quantity purchased assuming that other prices and utility are held constant. It answers the how utility will change as a result of a change in relative prices of that specific food.
In case of an inferior good, customer maximizes utility at point a. However, the prices of good x falls to Px0 making the budget line to rotate. As a result, a point b is formed when the budget line meets the indifference curve. This is known as the price effect. To attain a new equilibrium, M is reduced to M* where a new equilibrium bundle is formed. Therefore, substitution effect is the change of good X from point a to b. The income effect shows that as the income increases,the quantity of good X desired reduces from c to b.
For a normal good, income elasticity of demand is positive. On the other hand, elasticity of demand for an inferior good is negative (Frank, 2007 pg 149). This therefore clearly indicates that for a normal good, increase in prices leads to decrease in demand whereas an increase in prices leads to increase in demand for an inferior good. Therefore, normal good are more elastic than inferior ...Download file to see next pagesRead More
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