Managerial Economicsintermediate
Explain how the substitution effect and income effect help account for the law of demand.
Answer
When a good's price rises, buyers may substitute toward other goods that are now relatively cheaper. The higher price also reduces the purchasing power of a given income, which can lower the quantity buyers can afford. These effects help explain why quantity demanded generally falls as own price rises, other things equal.
Explanation
### The concept
The law of demand describes an inverse relationship between a good's own price and quantity demanded, assuming other relevant factors stay unchanged. The substitution effect occurs when a buyer switches toward alternatives because relative prices have changed. The income effect occurs because a price change alters what the buyer can afford with a given income. Together, these mechanisms help explain the usual downward relationship.
### What a good answer covers
- States that the law concerns own price and quantity demanded.
- Explains substitution toward relatively cheaper alternatives.
- Explains the change in purchasing power.
- Recognizes that the relationship is stated other things equal.
### Terms
- **Substitution effect**: A change in buying caused by a change in a good's price relative to alternatives.
- **Income effect**: A change in buying caused by the effect of a price change on purchasing power.
### Remember
A higher price can make alternatives more attractive and reduce what a buyer can afford.
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