Chapter 20, Problem 2CTQ

To determine

The impact of price fall on the demand for the app due to the income and substitution effect

Introduction:

Substitution effect or substitutes- As the price of a good/service rises, the consumers, working under the assumption of rationality, look for substitutes of this good/service yielding the same or nearly the same utility. The cheaper substitutes thus come to be a part of the consumers’ consumption basket. The demand for the good thus falls and that for the substitute rises. The demand for the goods with close substitutes like tea and coffee or coke and Pepsi is thus highly elastic.

This is also known as the cross-price elasticity of demand et_c. It shows the percentage change in the quantity demanded of a good, let’s say X, as the price of its substitute Y changes. Algebraically, it is written as:

$e_c=\frac{\%\Delta Q_X}{\%\Delta P_Y}$

Income Effect- The increase in the price causes a fall in the real income of the consumers. Real income is the nominal income adjusted for the prices. If the same nominal income is able to purchase fewer units of a good than before due to a rise in the price, the income is said to have lost its purchasing power and thus reduced in real terms. Further, if the proportion of income spent on the good is very high, a rise in its price will lead to a significant cut or no purchase of the good as it would cause the real income to fall significantly. On the other hand, if the proportion of income spent is small, an increase in price would not affect the real income much and the consumer changes the consumption only minimally. The price elasticity of demand for the good on which a higher proportion of the income is spent thus elastic while that for the good on which a small proportion of the income is spent is relatively inelastic.

This is also known as the income elasticity of demand e_Y. It shows the percentage change in the quantity demanded of a good, let’s say X, as the income(Y) of the consumer changes. Algebraically, it is written as:

$e_Y=\frac{\%\Delta Q}{\%\Delta Y}$