Explain the terms "substitution effect" and "income effect" when they are used in the context of microeconomic
Answer:
When the price of a good X changes, the consumer's response comes from two sources:
1. Relative to other goods, X is now cheaper or more expensive;
2. Purchasing power has changed. (This may be barely noticeable for some goods, but may be significant say for apartment rental).
To isolate the two, simply imagine the ff scenario: for a price increase (decrease), subtract (add) enough income so as to keep the consumer on the same level of overall satisfaction, and watch the resulting changes in consumption away from (toward) X and toward (away from) other goods. This is the substitution effect.
Then give back (take away) the income; the consequent adjustment is the income effect.
I am no economist but as for substitution effect:
I take that to be if one product or service becomes too expensive people will spend the money on some thing else that will give them satisfaction but at less cost.
Like, if air travel becomes too expensive they may vacation closer to home. Staying home vs eating out,. taking the bus vs high gas prices.
I am sure that you can think of many things you would do different if some thing you now do becomes more expensive.
More or less income for a person will effect if they will spend more on something or less.
With more money people will spend to up grade what they buy. With less they have to cut back.
It is some what predictable what people will do when things change economically.
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