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IAI Actuarial Core Principles · Business Economics · Consumer demand and behaviour

A household buys a good priced at Rs 20 and spends Rs 4,000 a month on it. Price rises to Rs 25. The total fall in quantity is 40 units, of which the substitution effect accounts for 30 units. Quantity demanded is 200 units initially. Which statement is correct?

Initial quantity is 200 units and the total fall is 40, giving 160. Since the substitution effect explains 30 units, the income effect is the remaining 10 units. It reduces demand after a price rise, so the good is normal.

  1. AThe income effect is 30 units and the good is inferior
  2. BThe income effect is 10 units reducing demand, so the good is normal, and the final quantity is 160Correct
  3. CThe income effect is 10 units raising demand, so the good is inferior, and the final quantity is 160
  4. DThe income effect is 70 units and the final quantity is 130
  5. The income effect is 10 units reducing demand, so the good is normal, and the final quantity is 240

Explanation

Initial quantity is 4,000/20 = 200 units. Final quantity is 200 - 40 = 160. Income effect = 40 - 30 = 10 units, in the same direction as the substitution effect (both reduce demand) after a price rise, which indicates a normal good.

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