Answer to Question #295732 in Microeconomics for NSB

Question

c) Clearly describe substitution effect and income effect for a fall in price for a normal good and an inferior good

Answer 1

For normal goods, the income effect and the substitution effect are cumulative, since a decrease in the price of these goods leads to an increase in demand for them. For example, a consumer, having a given income that does not change, buys tea and coffee in a certain ratio, which are normal goods. In this case, the substitution effect works as follows. A fall in the price of tea will lead to an increase in demand for it. Since the price of coffee has not changed, coffee is now relatively (comparatively) more expensive than tea. A rational consumer replaces relatively expensive coffee with relatively cheap tea, increasing the demand for it. The income effect is manifested in the fact that the decrease in the price of tea made the consumer somewhat richer, i.e., led to an increase in his real income. Since the higher the income level of the population, the higher the demand for normal goods, and the increase in income can be directed both to the purchase of an additional amount of tea and coffee. Therefore, in the same situation (decrease in the price of tea with the price of coffee unchanged), the substitution effect and the income effect lead to an increase in the demand for tea. The income effect and the substitution effect operate in the same direction. For normal goods, income and substitution effects explain the increase in demand when the price falls and the decrease in demand when prices rise. In other words, the law of demand is fulfilled.

For inferior goods, the effect of income and substitution effects is determined by their difference. For example, a consumer, having this income, purchases natural coffee and a coffee drink, which is a product of the lowest category, in a certain ratio. In this case, the substitution effect works as follows. A fall in the price of a coffee drink will lead to an increase in the demand for it, since the drink is now a relatively cheap good. Since the price of coffee has not changed, coffee is a relatively (comparatively) expensive commodity. A rational consumer replaces relatively expensive coffee with a relatively cheap coffee drink, increasing demand for it. The income effect is manifested in the fact that a decrease in the price of a coffee drink made the consumer somewhat richer, i.e., led to an increase in his real income. Since the higher the level of income of the population, the lower the volume of demand for lower goods, the increase in the real income of the consumer will be directed to the purchase of an additional amount of coffee. As a result, a decrease in the price of a coffee drink (a lower category product) will lead to a drop in demand for it and an increase in demand for coffee (a product of a higher category). Therefore, in the same situation (a drop in the price of a coffee drink at a constant price of coffee), the substitution effect leads to an increase in the demand for a coffee drink, and the income effect leads to a decrease in the demand for it. The income effect and the substitution effect work differently.

For inferior goods, the resultant of both effects depends on the extent to which each influences consumer choice. If the substitution effect is stronger than the income effect, then the demand curve for the inferior good will have the same shape as the normal good. Thus, the law of demand is fulfilled. If the income effect is stronger than the substitution effect, then the quantity demanded for an inferior product falls when the price of that product falls. In other words, the law of demand is not fulfilled here.