Suppose the price of a good rises. When will the resulting income effect reduce the quantity demanded of the good
A Only when the good is normal.
B Always. Only when the good is inferior.
C Whenever the good is a non-Giffen good.
The correct answer and explanation is:
The correct answer is A: Only when the good is normal.
When the price of a good rises, it creates two main effects on the quantity demanded: the substitution effect and the income effect. The substitution effect causes consumers to buy less of the good as its price rises because they switch to cheaper alternatives. The income effect reflects the change in purchasing power due to the price increase. When the price of a good rises, consumers’ real income decreases, leading to a decrease in the quantity demanded if the good is normal.
For normal goods, the income effect works in the opposite direction of the price change. When the price of a normal good rises, the consumer feels poorer, which decreases their demand for that good. This happens because a reduction in purchasing power reduces the amount of goods the consumer can afford to buy at the same price level. In simpler terms, people can no longer afford to buy as much of the normal good due to the price increase.
For inferior goods, however, the income effect operates differently. When the price of an inferior good rises, people may actually increase their demand for that good because their reduced real income makes them buy more of the cheaper inferior good in place of more expensive alternatives. This is why the income effect for inferior goods leads to an increase in quantity demanded when prices rise, rather than a decrease.
A non-Giffen good is a type of inferior good where the income effect is strong enough to outweigh the substitution effect, leading to higher demand despite a price increase. However, for non-Giffen goods, the general rule about the income effect reducing quantity demanded does not apply. Thus, the income effect will reduce quantity demanded only for normal goods.