The effect of a price change on the quantity demanded of a good can be analyzed through the concepts of the income effect and the substitution effect. These effects are used in economic theory to understand how consumers respond to changes in the price of a good while keeping their real income constant.
Income Effect:
The income effect is the change in the quantity demanded of a good due to a change in the consumer’s real income resulting from the price change. Real income refers to the purchasing power of the consumer’s income after accounting for changes in prices.
Normal Goods: For normal goods, a decrease in the price of the good increases the consumer’s real income. As a result, the consumer can afford to buy more of the good and other goods as well. This leads to an increase in the quantity demanded of the good.
Inferior Goods: For inferior goods, a decrease in the price of the good also increases the consumer’s real income. However, since inferior goods are of lower quality or less desirable, the consumer may choose to buy more of other, higher-quality goods instead. This leads to a decrease in the quantity demanded of the inferior good.
Substitution Effect:
The substitution effect is the change in the quantity demanded of a good due to its relative price change compared to other goods, assuming the consumer’s real income remains constant.
Price Decrease: When the price of a good decreases, it becomes relatively cheaper compared to other goods. As a result, consumers may substitute some of the more expensive goods with the now cheaper good. This leads to an increase in the quantity demanded of the good.
Price Increase: Conversely, when the price of a good increases, it becomes relatively more expensive compared to other goods. Consumers may now prefer to substitute some of the more expensive good with other, relatively cheaper goods. This leads to a decrease in the quantity demanded of the good.
Total Effect:
The total effect of a price change on the quantity demanded of a good is the combined effect of the income effect and the substitution effect. The magnitude and direction of the total effect depend on the relative strength of these two effects.
If the income effect dominates, the total effect leads to an increase in the quantity demanded when the price of the good decreases and a decrease in the quantity demanded when the price of the good increases.
If the substitution effect dominates, the total effect leads to an increase in the quantity demanded when the price of the good decreases and a decrease in the quantity demanded when the price of the good increases.
Understanding these effects is crucial for businesses, policymakers, and economists to predict consumer behavior and make informed decisions regarding pricing strategies, welfare analysis, and market equilibrium.