SUBSTITUTION AND INCOME EFFECTS OF A PRICE CHANGE.
How it is possible for a labour supply curve to bend backward, and the implication for the likely impacts of an income tax.
INTRODUCTION.
The concept of marginal utility has been a valuable way to understand the fundamental law of downward-sloping demand. Nevertheless, over last few decade economists have developed an approach to analysis of demand, one that makes no mention of marginal utility. This approach makes use of the device known as indifference curves. This approach separates the income effect and substitution of a price change.
This essay is discussing further on the subject of the income effect and substitution effect of a change of price. Here, the definition of both approaches are explained clearly, the main features of both are summarised and see that it leads consistently to the desired result, and the distinction between both of them is explored as well. By looking at those explanations about the income and substitution effect, we can see why the quantity demanded of a good declines as its price rises. .
Moreover, based on the explanations above, this essay also gives out the discussion concerning the relationship between the substitution effect and the income effect with the labour supply. It describes how those substitution and income effects can make the labour supply curve possible to bend backward, and analyses the implications of this discussion for the likely impact of an income tax cut.
INCOME AND SUBSTITUTION EFFECT OF A PRICE CHANGE.
The income effect of a price change is the change in the quantity demanded, which results from the change in real income due to the price change, even if the price had not changed. The substitution effect of price change is the change in the quantity of good that would be demanded if its price had changed but the individual's real income (that is, his level of utility) had remain constant (H.