2. Kognity 2.1.

3 / Use an example to explain how the income effect and substitution

effect can explain the downward sloping demand curve (which reflects the law of
demand).

Consider a situation where the price of gasoline, a good that many people use as a transportation fuel,
increases. There are two ways in which this price change can impact the demand for gasoline: the
income effect and the substitution effect. The income effect comes in because an increase in the price
of gasoline means that consumers have less money to spend on other goods and services. If the increase
in gasoline prices is substantial, some consumers may decide to reduce their consumption of gasoline in
order to have more money left over for other things they want or need. This leads to a decrease in
demand for gasoline, shifting the demand curve downwards. “This means that their real income in
terms of this good has increased, and therefore they can demand a larger quantity of it.”(kognity)

Suppose that there is a decline in the prices of train travel. This decrease in price makes train travel a
more affordable option for consumers. As a result, some people who previously traveled by air may
choose to substitute train travel for air travel, since it is now a more cost-effective option. This shift in
consumer behavior decreases the demand for air travel and shifts the demand curve for air travel
downwards. This example illustrates how the substitution effect can cause a downward sloping demand
curve. When the price of a good decreases, consumers are more likely to substitute that good for others
that are currently in their consumption bundle. This change in consumer behavior decreases the
demand for the other goods, resulting in a downward shift in their respective demand curves. This
reflects the law of demand, which states that as the price of a good decreases, the quantity demanded
by consumers increases.

3. Using the example of the diminishing marginal utility gained from consuming
successive slices of pizza, explain how the law of diminishing marginal utility can explain
the downward sloping demand curve (Hint: why is the consumer willing to buy another
slice only if the price falls?).
Consider a consumer who is eating pizza. The first slice of pizza provides a large amount of satisfaction to
the consumer, as their hunger is satisfied and they enjoy the taste of the pizza. However, as the
consumer consumes more slices, the satisfaction they gain from each additional slice decreases. This is
because the consumer has already satisfied their hunger and is starting to feel full, so each additional
slice provides less marginal utility. This concept of diminishing marginal utility can help explain why the
demand curve for pizza is downward sloping. At first, when the consumer is still hungry, they are willing
to pay a high price for a slice of pizza, as it provides a large amount of satisfaction. However, as they
consume more slices and the marginal utility gained from each additional slice decreases, the consumer
is willing to pay less for each successive slice. This means that as the price of pizza decreases, the
consumer is more likely to buy another slice, as the satisfaction gained from it is still greater than the
cost.