Principles of Economics - Demand Curves - Assignment Example

When analyzing the income and substitution effect, we need to consider the income change that is necessary to move the consumer to the required utility level while maintaining the initial prices. This is called the income effect. The movement that occurs along the new indifference curve from the intermediate point to the new equilibrium as the price of product changes is thus the substitution effect.

The actual level of utility changes along the demand curve. As the price of good x falls, the individual moves to a higher indifference curve it is assumed that nominal income is held constant as the demand curve is derived this means that real income increases as the price good X falls. The common question that the Marshallian demand is likely to answer is the effect of change in the price of a good in relation to its quantity. It explains how consumers will behave as a result of changes 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 how the utility will change as a result of a change in relative prices of that specific food. Substitution and income effect of an inferior good In the case of an inferior good, the customer maximizes utility at point a. However, the prices of good x fall to Px0 making the budget line rotate. As a result, 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, the 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.