Question

Match the scenarios with the economic concepts they illustrate. positive externality substitution effect negative externality income effect

Answer 1

• Positive externality: is a positive side-effect that is generated by the economic activity, in other words,by the process of production or consumption of goods and services aimed to satisfy human needs. Initially it is not an objective of such activity, but indeed is a consequence of it. For example, if a person decides to walk to work less pollution is generated and this is positive for everybody.
• Negative externality: negative side-effect generated as a consequence of the economic activity. For example, when an industry manufactures a good it might be at the same time polluting the air with its fumes.
• Substitution effect (SE): the law of demand indicates than when the price of a good or service is modified, the quantity demanded changes, generally in the opposite direction. Therefore, the substitution effect is the part of the variation of the quantity demanded that takes place due to the change in the relative prices. For example, if the price of a product rises, the SE is due to the fact that the product mentioned has become more expensive than before if compared to other goods, and part of the consumers that constitute the demand might decide to substitute the expensive good for other similar cheaper good.
• Income Effect (IE). Is the other effect that takes place when price modifications affect the quantity demanded. Is the part of the variation of the quantity demanded that takes places due to the modification of the real income and the purchasing power enjoyed by consumers when the prices are modified. If the price of a product increases, the real income, the number of units that the consumer can purchase, changes.

Answer 2

The rising price of gold causes people to buy silver jewelry instead.
substitution effect

When the price of chicken increases, families reduce their chicken intake substantially.
income effect

A new factory in a village provides livelihoods for the villagers.
positive externiality

A new factory in a village causes noise pollution.
negative externiality

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