Question

Suppose that Sally spends all her money on coffee and tea. Assume that both are normal goods. Define and explain how both the income and substitution effect of an increase in the price of tea will affect her demand for coffee.

Answer 1

Income effect in the given case, shows the impact upon income and subsequent change in demand in tea due increase in price of team, while substitution effect tells the impact upon the demand of other substitutes such as coffee due to increase in price of tea.

Increase in the price of tea, will reduce the income considerably if same amount of tea is consumed, so leading to reduced consumption of coffee. So, as an income effect, demand for tea will decrease so that consumption of coffee is not affected. Though, as a substitution effect, people would like to substitute tea with coffee due to increase in prices. It will cause increase in the demand of coffee.