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

When the price of a normal good falls, which statement correctly describes the substitution and income effects on the quantity demanded?

For a normal good, a price fall raises quantity demanded through both effects: the substitution effect shifts consumers towards the relatively cheaper good, and the income effect raises real purchasing power, which increases consumption of a normal good.

  1. AThe substitution effect raises quantity demanded and the income effect lowers it
  2. BThe substitution effect raises quantity demanded and the income effect also raises itCorrect
  3. CThe substitution effect lowers quantity demanded and the income effect raises it
  4. DBoth effects lower quantity demanded because the good is now cheaper relative to income
  5. The substitution effect is zero and only the income effect operates

Explanation

A price fall makes the good relatively cheaper, so consumers substitute towards it, raising quantity demanded. It also raises real income, and for a normal good higher real income increases consumption. Both effects therefore work in the same direction.

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