1.

Define income effect and substitution effect.

Answer»

1. Income effect:

When the monetary income of the consumer remains constant, but price of the good falls then his real income rises. Real income means the purchasing power of money income. When real income rises, a consumer can buy more quantity of a good and therefore its demand may rise. This is known as income effect on demand.

2. Substitution effect:

  • When price of the concerned good falls, it becomes relatively cheaper than its substitutes.
  • Hence, a consumer will reduce the consumption of substitute goods and increase the demand for the concerned good. This is called substitution effect.


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