In the budget constraint framework, when the price of a good rises and demand for the other good decreases, what can you say about the size of the substitution effect compared to the income effect?

Question

Alfie

Business

22 December, 15:36

In the budget constraint framework, when the price of a good rises and demand for the other good decreases, what can you say about the size of the substitution effect compared to the income effect?

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Answers (1)

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Jakob Chase · Answer 1

The increase in demand of the product with the higher price or decrease in demand for the other goods is because the substitution effect is outweighed by the income effect of price increase.

Explanation:

The above explanation in economics refers to Giffen Good. The idea behind this concept Giffen is that if you do not have money and there is an increase in the price of a fundamental product such as bread, it is still impossible to afford other alternatives, hence you will go ahead to buy bread or avoid buying any of the product. Hence, the demand for other product will also decrease in this case. This means that the demand for product with higher price or decrease in other substitute product is due to the fact that the income effect outweighs the substitution effect. Hence people do not have the money to even afford the alternative product.