QUEStION3 a Analyze the substitution effect and the income e

QUEStION:3 a) Analyze the substitution effect and the income effect of an increase in the price of second-hand clothes. Can we say what the overall effect will be? Page 1 of 2 ECO 2023 Hint: Second-hand clothes are an inferior good. b) If low-carbohydrate diets become very popular, what do you expect to happen to the D for bread and donuts? What about the D for veggies?

Solution

a)

The substitution effect refers to the change in quantity demanded because of the change in price of a good due to availability of substitution of relatively cheaper good. When there is an increase in the prices consumers will replace more expensive goods with less costly replacements.

Income effect is the change in demand of a good because of the change in a consumer’s discretionary income. The income effect is seen in two conditions when a person’s aggregate income increase or if the relative price of the good decreases. Both conditions lead to increase in the amount of discretionary income available.

Some substitute goods are also considered as inferior goods. An inferior good is a product whose demand increases when the relative price of another good increases & decreases as a person’s income increase. Here for example if we take second hand clothes whose demand will increase if the prices of new clothes increases & whose demand will decrease as a person’s income increases. Therefore if there is an increase in price of second hand clothes its demand will decrease. Individuals will tend to buy new clothes as they can afford more expensive goods.

b)

If low carbohydrate diets become popular, the demand for bread & donuts may decrease due to substitution effect as people will replace it with other available substitutes. The demand for veggies will increase. Normal goods are those whose demand increases as income increases. Since food is a normal good people tend to buy more quality goods as their income increases.