Explain the income and substitution effects and use the concepts to describe what happens when the price of a product decreases

Question

Please provide the best answer for the statement.

Answer 1

Income and substitution effects explain the inverse relationship between price and quantity demanded. The income effect is the effect of a change in price on consumers’ real incomes, and therefore on the quantity of that product demanded. A decrease in price means that more real income is available to buy subsequent amounts of the product. The substitution effect is the effect of a change in a product’s price on its expensiveness relative to other substitute products’ prices. A decrease in price for a product with no change in the prices of substitutes means that the product has become relatively less expensive compared to its substitutes. Consumers, therefore, can afford to buy more of this product and have an incentive to buy less of the substitutes, whose prices are relatively higher than was previously the case.