Fact 1: "The substitution effect(SE) must ALWAYS be negative (i.e. goes in the opposite direction to the change in PRICE). The income effect(IE) can be either positive or negative."
Fact 2: "SE and IE can go in the same direction or they can go in opposite directions."
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1) Now, what does it MEAN to say that the INCOME effect is positive or negative? I simply do not understand this at all...it's very confusing...
2) When they say that "the substitution and income effects go in the SAME direction", does it mean that both the substitution and income effects are "negative"? (since SE is ALWAYS negative, if they go in the same direction, IE must also be "negative" as well.)
I am puzzled...can someone please explain?
Thank you very much!
The substitution effect is always negative. If price goes up, you want to buy less (and switch to something else). period.
The income effect depends on how much money is left over after the substitution effect. If the price of milk goes up by 10% and you cut gallons purchased by 5%, you are spending more money on milk -- correct. This is the income effect. It says you have less money to spend on everything else. (negative). However if you cut gallons by 20% then you are spending less on milk and have more money to spend on everything else. (positive)
What you spend on everything else depends on the character. For a normal good, the more income you have, the more you want to purchase (like t-bone steaks.) An inferior good has a negative relationship. As income goes up, the less you want to purchase. (Like gruel or oatmeal.)
1) When we say that the income effect is positive or negative, we are referring to the direction in which a change in income affects the quantity demanded of a good or service. If the income effect is positive, it means that an increase in income leads to an increase in the quantity demanded of a good or service. Conversely, if the income effect is negative, it means that an increase in income leads to a decrease in the quantity demanded of a good or service.
To understand why the income effect can be positive or negative, we need to consider the concept of normal goods and inferior goods. Normal goods are those for which the quantity demanded increases as income increases, while inferior goods are those for which the quantity demanded decreases as income increases. For example, a luxury item like fine dining might be considered a normal good because people tend to demand more of it as their income increases, while cheap fast food might be considered an inferior good because people tend to demand less of it as their income increases.
2) When we say that the substitution and income effects go in the same direction, it means that both effects work together to either increase or decrease the quantity demanded in response to a change in price or income. This does not necessarily mean that both effects are negative.
Let's consider an example to understand this better. Suppose the price of a good increases. The substitution effect, in this case, refers to the change in quantity demanded caused by consumers substituting the now relatively more expensive good with its substitutes. The income effect, on the other hand, refers to the change in quantity demanded caused by the change in purchasing power resulting from the price increase.
If the substitution effect is larger than the income effect, it means that consumers are more responsive to the price change and opt for substitutes. In this case, both effects would be negative since the quantity demanded decreases. However, if the income effect is larger than the substitution effect, it means that consumers are more responsive to the change in purchasing power and may still consume more of the relatively more expensive good. In this case, the substitution effect would be negative (as the quantity demanded decreases) but the income effect would be positive (as the quantity demanded increases).
In summary, when we say that the substitution and income effects go in the same direction, it means that they both contribute to either increasing or decreasing the quantity demanded. However, the direction (positive or negative) of each effect depends on the specific circumstances such as the type of good and the relative magnitudes of the effects.