Question

5. If a price of normal good falls, its quantity demanded increases. Explain this phenomenon with substitution effect and income effect with an example.

6. Explain how diminishing marginal rate of substitution applies to your daily living. Give a detailed example.

Answer 1

5. If there is a fall in the price of normal goods then due to the substitution effect it makes the other goods in the market relatively more costlier thereby increasing the demand of the good because people will only go for less costly good. Due to the income effect, the fall in price of a good will increase the purchasing power of individuals which in turn will lead to an increase in quantity demanded of the good. So, both the income effect and the substitution effect will work in same direction when the price of a normal good falls.

6. The rate at which one commodity can be exchanged for other commodity to maintain the same level of satisfaction is called marginal rate of substitution. The marginal rate of substitution diminishes because in order to gain one additional unit of one good, an individual is willing to give up lesser and lesser quantities of the other good.

For example:

Coffee Biscuits MRS 1 11 2 7 4 4 3 4 2 2 1 1

The consumer is willing to give up 4 biscuits in order to have a second cup of coffee. The same consumer is willing to give up only 3 biscuits in order to have a third cup of coffee. The marginal rate of substitution keeps on decreasing. This means that the consumer is getting highest satisfaction on consuming first cup of coffee and each additional cup of coffee leads to an increase in total satisfaction at a diminishing rate.