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

For an inferior good whose price rises, but which is not a Giffen good, which statement is correct?

The substitution effect reduces quantity demanded as the good becomes relatively dearer. The income effect works against it because falling real income increases demand for an inferior good. Since the substitution effect is larger in the non-Giffen case, net quantity demanded falls.

  1. AThe income effect is negative and outweighs the substitution effect, so quantity demanded rises
  2. BThe substitution effect is positive and the income effect is negative, so quantity demanded is unchanged
  3. CThe substitution effect lowers quantity demanded, the income effect raises it, and the substitution effect is larger, so quantity demanded fallsCorrect
  4. DBoth effects raise quantity demanded, so the demand curve slopes upward
  5. The substitution effect is zero because the good is inferior

Explanation

A price rise cuts real income. For an inferior good, lower real income increases consumption, so the income effect opposes the substitution effect, which reduces demand. If the substitution effect dominates, which is the non-Giffen case, total quantity demanded still falls.

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