Question

The law of downward sloping demand can be explained in terms of:

• A. The substitution effect
• B. The income effect
• C. Both the substitution and income effect
• D. Neither the substitution nor income effect

Hint:

Remember: "Price Effect = Substitution Effect + Income Effect" (the Slutsky/Hicks decomposition). This equation is a fundamental concept in consumer theory.

Answer 1

The Correct Option is C

Step 1: Understanding the Concept:
The Law of Demand states that, other things being equal, the quantity demanded of a good increases as its price falls, resulting in a downward-sloping demand curve.

Step 2: Detailed Explanation:
When the price of a commodity decreases, two distinct microeconomic forces drive consumers to purchase more of it:
1. The Substitution Effect: As the price of the good falls, it becomes relatively cheaper compared to its substitutes. Consumers naturally substitute away from more expensive goods toward this cheaper alternative.
2. The Income Effect: A lower price increases the consumer's real purchasing power (real income), allowing them to buy more of the good with their existing nominal income, assuming the good is normal.
Thus, both the substitution effect and the income effect work together to explain why the demand curve slopes downward.

Step 3: Final Answer:
The downward slope is explained by both effects, matching Option (C).