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Difficulty: MediumIncome and Substitution Effects on Demand

If the price of an inferior commodity (which is not a Giffen good) decreases, how do the substitution effect and the income effect interact to influence the quantity demanded of the commodity?

  1. The substitution effect increases quantity demanded, while the income effect reduces quantity demanded, but the substitution effect is stronger.Answer
  2. B
    Both the substitution effect and the income effect operate in the same direction to increase the quantity demanded.
  3. C
    The substitution effect reduces quantity demanded, while the income effect increases quantity demanded, resulting in no overall change.
  4. D
    The income effect reduces quantity demanded by a greater amount than the substitution effect increases it, causing total quantity demanded to fall.

Answer

The substitution effect increases quantity demanded, while the income effect reduces quantity demanded, but the substitution effect is stronger.
When the price of an inferior commodity falls, it becomes relatively cheaper, causing consumers to substitute toward it (positive substitution effect). However, the price drop increases purchasing power (real income), which causes consumers to buy less of an inferior good (negative income effect). Because it is not a Giffen good, the substitution effect dominates the income effect, leading to a net increase in quantity demanded.

Step-by-Step Solution

1
Analyze the substitution effect of a price reduction
A lower price makes the good relatively cheaper compared to substitutes, so the substitution effect always increases quantity demanded of the good.
The substitution effect is strictly negative with respect to price (moving in the opposite direction of price change).
2
Analyze the income effect of a price reduction for an inferior good
A price reduction increases real income. For an inferior good, an increase in real income leads to a decrease in quantity demanded.
By definition of inferior goods, demand moves inversely with real income.
3
Determine the net total price effect for a non-Giffen inferior good
The total price effect remains positive (overall quantity demanded increases) because the substitution effect outweighs the income effect.
For standard inferior goods, the positive substitution effect is larger in magnitude than the opposing negative income effect.

Key Concept

Decomposition of Price Effect for Inferior Goods
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Topics

Income and Substitution Effects on Demand

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