Question

Discuss the price effect on consumer's equilibrium using diagram and numerical examples.

Answer 1

The price effect on consumers demand is composed of the income effect and the substitution effect. In the event of the good being a normal good then as income rises the income effect is positive and the income effect and substitution effect moves in the same direction. In the event of the good being an inferior good the demand for the good falls as income increases and if the income effect outweighs the positive substition effect then the good becomes a Giffen good. In the diagrams below, on the left when the prices falls the consumer moves from equilibrium A to B. The split of the income and substitution effects is shown below. In the event of the good being inferior, the income effect will offset the substitution effect.