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Difficulty: HardIncome and Substitution Effects on Demand

A consumer allocates household income between cassava flour and yam. Cassava flour is classified as an inferior good, but not a Giffen good. If the market price of cassava flour increases, which of the following correctly describes the directional impacts of the substitution effect and the income effect on the quantity of cassava flour demanded?

  1. The substitution effect reduces quantity demanded, while the income effect increases quantity demanded, resulting in an overall net decrease in quantity demanded.Answer
  2. B
    Both the substitution effect and the income effect reduce quantity demanded, reinforcing an overall net decrease in quantity demanded.
  3. C
    The substitution effect increases quantity demanded, while the income effect reduces quantity demanded, leading to an overall net increase in quantity demanded.
  4. D
    The substitution effect reduces quantity demanded, but the income effect increases quantity demanded by a greater magnitude, resulting in an overall net increase in quantity demanded.

Answer

The substitution effect reduces quantity demanded, while the income effect increases quantity demanded, resulting in an overall net decrease in quantity demanded.
When the price of a good increases, the substitution effect always causes a decrease in quantity demanded as consumers shift toward relatively cheaper alternatives. For an inferior good, a rise in price lowers real income, which leads consumers to purchase more of the inferior item (a positive income effect). Because the commodity is specified as a non-Giffen inferior good, the negative substitution effect is stronger than the positive income effect, causing the net total price effect to be negative (overall decrease in quantity demanded).

Step-by-Step Solution

1
Analyze the direction of the substitution effect following a price increase.
The substitution effect is always negative relative to price changes. An increase in price makes cassava flour relatively more expensive than yam, prompting the consumer to substitute away from cassava flour (reducing quantity demanded).
The substitution effect measures movement along an indifference curve due to relative price changes alone.
2
Analyze the direction of the income effect for an inferior good following a price increase.
A price increase reduces real purchasing power. Because cassava flour is an inferior good, a decline in real income leads the consumer to demand more of it (positive income effect).
Inferior goods have an inverse relationship between real income and quantity demanded.
3
Compare the relative magnitudes of the substitution effect and income effect for a standard (non-Giffen) inferior good.
For a non-Giffen inferior good, ∣Substitution Effect∣>∣Income Effect∣|\text{Substitution Effect}| > |\text{Income Effect}|. Thus, the reduction from substitution exceeds the increase from the income effect, yielding a net decrease in total quantity demanded.
A Giffen good requires the income effect to exceed the substitution effect; since this good is non-Giffen, the law of demand still holds.

Key Concept

Decomposition of Total Price Effect for Inferior Goods
Estimated Time:2m 0s
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Topics

Income and Substitution Effects on Demand

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