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Substitution vs Income Effect & Diminishing Marginal Utility

1) Explain how a price change is affected by (a) the substitution effect, (b) the income effect.

2) If someone is very thirsty and drinks five glasses of water, explain how the principle of the diminishing marginal utility is related to drinking each glass of water.

3) Explain the relationship between the ratio of marginal utility and the price of each good consumed in consumer equilibrium.

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Hello Student,

In order to answer the first question, you first need to note that the change in the price of a good or service will cause a change in the quantity demanded of that same good or service. By how much quantity demand will change depends on the income or substitution effect. By definition, the income effect is, "the change in quantity demanded that results because a change in the demand price of a good affects real income (that is, the purchasing power of income) even though nominal income remains the same." The substitution effect on the other hand results because a ...

Solution Summary

This solution provides you with information about how a price change is affected by either substitution or income effect; it looks at the principle of diminishing marginal utility; and it also provides links which gives information about the relationship between the ratio of marginal utility and the price of each good consumed in consumer equilibrium.

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