Question

Suppose that consumers' preferences are well behaved in that properties 4-1 to 4-4 are satisfied. Furthermore, assume that X is a normal good, Y is an inferior good, and the price of good Y decreases. Then, which of the following effects is known with certainty?

1. The income and substitution effects will have competing effects, leading to an indeterminate impact on the consumption of good Y.

2. The income and substitution effects will reinforce one another, leading to an overall increase in the consumption of good Y.

3. The income and substitution effects reinforce one another leading to an overall decrease in the consumption of good X.

4. The income and substitution effects will reinforce one another, leading to an overall decrease in the consumption of good Y.

5. The income and substitution effects will reinforce one another, leading to an overall increase in the consumption of good X.

Answer 1

The correct option is 1. This is because we know that the overall price effect can be divided in two parts, income effect and substitution effect.

Substitution effect will always take place in the opposite direction of price change. If the price increse, quantity of the concerned good will decrease. If the price of the good decreases (no mater normal or inferior), through substitution effect, its quantity will increase.

However, in case of inferior goods, the income effect is different. More of consumer's income implies more less comsumption of inferior goods. Thus, when we give consumer his held income back, he will comsume less of inferior goods.

This shows that the income effect and substitution effect will work in opposite directions in case of inferior goods and the result will be indeterminate.