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Explain the difference between income effect and substitution effect

Explain the difference between Income effect and Substitution effect

There is a difference between income effect and substitution effect but they are both are relative to each other, in fact the effects can't happen without the other also occurring. To define both terms; if a product has a price change such that it increases, then the consumer will feel they have less disposable income for this product (A) even though their real income has not changed. This is known as the income effect. The change in mood of the consumer to product (A) which is on sale will mean it will become less popular with the market because of the price increase. Consumers will therefore buy products (B or C) which are similar or substitute goods. This is known as the substitution effect. This idea will also take action if the price decreased then disposable income will increase, then more of the substituted good will be consumed. (J. Sloman 2006).

Other factors which result in a change of income effect and substitution effect are goods which are known as normal or inferior goods. These are goods which are a preference to the consumer themselves. There is no real example of a normal or inferior good. A normal good is one which as a demand increases so does the income for the goods increase.

The diagram shows the price of a rugby balls decreasing, therefore the budget constraint line has moved from A1 to A2 and more maybe purchased, which suggests that the consumer's income has increased. This is shown on the diagram as R1, the original amount which the consumer may purchase with the maximum utility (L1) available with the budget. Now with the substitution effect the amount available to buy with the same maximum utility has moved to R2 as the price of the rugby ball has decreased. Now the income effect, the maximum utility has moved to L2 as with the price change (decrease) of the rugby ball. The consumer can now purchase more of the same product (rugby ball) with the same income as before which means more utility is gained. From the graph both the substitution effect and income effect have been positive which suggests that for this product, the rugby ball is a normal good.

An inferior good is a product which as income for a consumer increases, demand for that product decreases

The diagram shows the price of the rugby ball has decreased, this means that the budget constraint has moved to from A1 to A2. Due to the substitution effect R1 has moved to R2 as more rugby balls maybe purchased, with the same utility (L1). Now due to the decrease in price and increase in income maximum utility has moved from L1 to L2, however the amount available to buy with the maximum utility crosses the budget constraint at a point (R3) which is smaller than R2 which shows the income effect has decreased. This suggests that for this example the rugby ball is an inferior good.

Explain the difference between GDP (Gross Domestic Product) and GNI (Gross National Income)

GDP (Gross Domestic Product) and GNI (Gross National Income) are different measures of growth (output) and income within the country however the main difference between them both is GDP takes into account the output earned within the country but not who the output is generated by such as a foreign ownership who's profits go abroad. Where as GNI takes into account income earned within the country, but if its ownership is foreign then these incomes will go abroad such as interest, wages, rent and profit and so are minuses but if the income is abroad it will come into the country of origin such as interest, wages, rent and profit which is added to GNI figures. (J. Sloman 2006).

GDP measures total output produced by one country this is by using the equation consumption (C) + investment (I) +government expenditure (G) + (exports (X) - Imports (M)) which this shows GDP at market prices which includes taxes in the form of VAT (indirect taxes), GDP at basic prices is another measure which minuses taxes and subsidies on products.

GNI was known as GNP (Gross National Product) and is only concerned with the income generated by the origin country no matter where the income is produced. GNI is calculated the same way as GDP is calculated, but 3 different aspects are included which convert the GDP figure to GNI, firstly 'employees compensation receipts from the rest of the world - payments to the rest of the world' (Lipsey & Chrystal 2007). This is implies if someone from the UK sells its products to a US firm then the GDP will add to the US but the GNI will come into the UK. Secondly, 'taxes for production paid to rest of the world plus subsidies received from rest of the world' (Lipsey & Chrystal 2007). This means that we measure GNI at market price and if a foreign product is bought the indirect tax goes abroad, and thirdly, 'property, employment and entrepreneurial income receipts from rest of the world minus payments to rest of the world' (Lipsey & Chrystal 2007). The idea of this is that if a property is owned abroad which is rent then the income generated will contribute to UK GNI figures but the GDP will go into the country the property is located in.

Figures which show GDP and GNI have shown that since 2001 GNI has been higher than UK GDP figures such as 2001, GDP '1,021,828 million' and GNI '1,027,915 million' (Blue Book, 2009) and since then the gap between these figures has increased in value such as in 2007, GDP '1,446,113 million' and GNI '1,471,255 million. There are areas which GDP and GNI exclude such as transfer of payments, gifts, unpaid activities, second-hand transactions, leisure, environmental costs and allowing for quality changes. This has caused a new GDP measure called HDI (Human Development Index) which takes into account the weaknesses of GDP and GNI.

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