The nature of the income effect of a price change depends on whether the good is normal or inferior. The income effect reinforces the substitution effect in the case of normal goods; it works in the opposite direction for inferior goods.
A normal good is one whose consumption increases with an increase in income. When the price of a normal good falls, there are two identifying effects:
- The substitution effect contributes to an increase in the quantity demanded because consumers substitute more of the good for other goods.
- The reduction in price increases the consumer's ability to buy goods. Because the good is normal, this increase in purchasing power further increases the quantity of the good demanded through the income effect.
In the case of a normal good, then, the substitution and income effects reinforce each other. Ms. Andrews's response to a price reduction for apples is a typical response to a lower price for a normal good.
An increase in the price of a normal good works in an equivalent fashion. The higher price causes consumers to substitute more of other goods, whose prices are now relatively lower. The substitution effect thus reduces the quantity demanded. The higher price also reduces purchasing power, causing consumers to reduce consumption of the good via the income effect.
Inferior GoodsIn the chapter that introduced the model of demand and supply, we saw that an inferior good is one for which demand falls when income rises. It is likely to be a good that people do not really like very much. When incomes are low, people consume the inferior good because it is what they can afford. As their incomes rise and they can afford something they like better, they consume less of the inferior good. When the price of an inferior good falls, two things happen:
- Consumers will substitute more of the inferior good for other goods because its price has fallen relative to those goods. The quantity demanded increases as a result of the substitution effect.
- The lower price effectively makes consumers richer. But, because the good is inferior, this reduces quantity demanded.
The case of inferior goods is thus quite different from that of normal goods. The income effect of a price change works in a direction opposite to that of the substitution effect in the case of an inferior good, whereas it reinforces the substitution effect in the case of a normal good.
Figure 7.5 Substitution and Income Effects for Inferior Goods
The substitution and income effects work against each other in the case of inferior goods. The consumer begins at point A, consuming q1 units of the good at a price P1. When the price falls to P2, the consumer moves to point B, increasing quantity demanded to q2. The substitution effect increases quantity demanded to qs, but the income effect reduces it from qs to q2.
Figure 7.5 "Substitution and Income Effects for Inferior Goods" illustrates the substitution and income effects of a price reduction for an inferior good. When the price falls from P1 to P2, the quantity demanded by a consumer increases from q1 to q2. The substitution effect increases quantity demanded from q1 to qs. But the income effect reduces quantity demanded from qs to q2; the substitution effect is stronger than the income effect. The result is consistent with the law of demand: A reduction in price increases the quantity demanded. The quantity demanded is smaller, however, than it would be if the good were normal. Inferior goods are therefore likely to have less elastic demand than normal goods.
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Upon successful completion of this unit, you will be able to:
- explain consumer preferences using concepts related to utility, including total utility and marginal utility;
- analyze a household’s budget line and describe how it changes when prices or incomes change;
- use indifference curves to explain the principle of diminishing marginal rate of substitution; and
- derive a demand curve from an indifference map by analyzing the quantity of the good consumed at different prices.
- Introduction to Consumer Choices Book
Read all the sections in this chapter for information on consumer choice, including utility, consumer equilibrium, consumer equilibrium demand, consumer surplus, budget constraint, and consumer equilibrium and indifference curves.
The Analysis of Consumer Choice Book
Read the Introduction and these two sections. Attempt the "Try It" problems at the end of each section. Take a moment to read through the stated learning outcomes for this chapter of the text, which you can find at the beginning of each section. These outcomes should be your goals as you read through the chapter.
Rules for Maximizing Utility Book
Read this article to learn more about how to calculate marginal utility per dollar. Make sure to answer the "Try It" questions.
- The Art of Choosing Page
This is an optional lecture and not a requirement of the course. The speaker talks about her ground-breaking research on how people make choices and explains attitudes towards their decisions.
Marginal Utility Page
Watch this video about marginal utility. Make sure that you understand that marginal utility is a concept in economics that is used to explain and measure the satisfaction that consumers get when consuming something. For example, if you consume a soda, we assume in economics that you get some sort of satisfaction, your "utility", and marginal utility will be the additional satisfaction that you get from consuming an additional soda.
Budget Line Page
Watch this video to learn how to depict the budget line in a graph. Remember that the budget line for a consumer will show the different combinations that can be bought for two goods given a fixed budget of some sort.
Equalizing Marginal Utility per Dollar Spent Page
Watch this video about equalizing marginal utility per dollar spent for two products. Keep in mind that this method is for figuring out what products would people prefer to spend on given a budget.
Adding Demand Curves Page
Watch this video about adding demand curves of individuals to arrive at the overall market demand curve. You can think of the overall demand curve as one that is composed of all of the individual demand curves.
Preference and Utility Page
Watch this lecture for an explanation of consumer theory, and especially mathematical representations of consumer preferences.
Indifference Curves Book
Read this section for additional details about indifference curves and consumer behavior.
Indifference Curve Analysis Book
Follow this resource to learn more about the concept of indifference curves. Make sure to answer the "Try It" quiz questions that show you the correct answer.
Types of Indifference Curves Page
Watch this video about to learn how to depict the different types of indifference curves depending on whether a product is a normal good, perfect substitute, or a perfect complement. You should consider reviewing the main reading material from Unit 4.1. that covered these concepts.
Optimal Point on Budget Line Page
Watch this video about the optimal point on a budget line. The optimal consumer choice in the indifference curve analysis is determined by the tangency condition between the marginal rate of transformation (MRT) and the marginal rate of substitution (MRS).
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