When it comes to calculating the subsitution effect, for some reason I get reall

Question

When it comes to calculating the subsitution effect, for some reason I get really confused as to why we calculate a new income. The book I'm reading says:

"Let us calculate how much we have to adjust money income in order to
keep the old bundle just affordable. Let m'
be the amount of money income
that will just make the original consumption bundle affordable."

I just don't understand why we want to keep the original consumption bundle afforable at a new price, couldn't we just consider that to be a new bundle? But I'm MOST confused as to what it means by "affordable," its't it already afforable? Can't we just interpt it as saying that even though price increased for the good, we'd just recieve less of a good but it would still be affordable? Maybe, I'm just dumb haha I don't know.

Explanation / Answer

Economics is all about allocation of resources efficiently. Money is also an important resource and its efficent allocation means having goods or services with minimum price and maximum utility.

Substitution comes into play when prices of that goods or services has risen with income stagnant or there is a change in income. Chnage in income could be adverse or favorable. In such cases subject will alter his buying pattern.

If a good increases in price.

The substitution effect states that an increase in the price of a good will encourage consumers to buy alternative goods. The substitution effect measures how much the higher price encourages consumers to use other goods, assuming the same level of income.

For a worker, there is a choice between work and leisure.

The substitution effect of higher wages means workers will give up leisure to do more hours of work because work has now a higher rewards.

The income effect of higher wages mean workers will reduce the amount of hours they work, because they can maintain a target level of income through less hours.

If the substitution effect is greater than income effect, people will work more. However, we may get to a certain hourly wage, where we can afford to work less hours.

If you buy more of a good when you have more money, that good is a normal good. If the price of a normal good increases, you buy less. If an increase in your income causes you to buy less of a good, that good is called an inferior good. Another exception is the case where an increase in price causes an increase in demand. This results in an upward-sloping demand curve, and the good is called a Giffen good. Giffen goods are theoretically possible, but very improbable, since it is unlikely that an increase in price causes increase in demand. One possible justification for a Giffen good is that people associate higher prices with status, luxury, and quality, so that a higher price might increase the perceived value of a good.

Related Questions

Navigate

• Browse (All)
• Browse W
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.