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Chapter 10: Problem 5

The chapter states that "when the price of an inferior good falls, the income effect and substitution effect work in opposite directions." Explain what this statement means.

Short Answer

Expert verified
An inferior good is one for which demand decreases as income increases. When the price of an inferior good falls, the income effect may lead consumers to buy less because they can now afford better-quality goods. At the same time, the cheaper price might cause consumers to buy more of the inferior good because it is now relatively less expensive compared to other goods. This is the substitution effect. Thus, the income effect and substitution effect work in opposite directions.

Step by step solution

01

Define Key Terms

The first thing you need to do is to define key terms. An 'inferior good' is one for which demand declines as the consumer's income rises. The 'income effect' is the change in consumption that results from changes in income, all else being constant. The 'substitution effect' refers to the change in consumption that results from a change in the relative prices of goods, all else being constant.
02

Explain Income and Substitution Effects in General

In general, when the price of a good falls, consumers will typically buy more of that good and less of other goods, this is the substitution effect. The income effect is that a lower price effectively increases purchasers' income, and consumers will usually buy more of all goods, including the one that has fallen in price.
03

Apply Concepts to Inferior Good

However, in the case of an inferior good, a lower price means that consumers have more 'real' income, and so they may buy less of this good, because they use their increased purchasing power to buy more higher-quality goods. This is the income effect. However, because the good is now cheaper relative to other goods, the substitution effect may cause consumers to buy more of it. Hence, the income effect and substitution effect work in opposite directions when the price of an inferior good falls.

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Most popular questions from this chapter

In an opinion column in the New York Times, advocating increased legal penalties for people who use ticket bots, Lin-Manuel Miranda, the star and creator of the musical Hamilton, wrote, "I want the thousands of tickets for shows, concerts and sporting events that are now purchased by bots and resold at higher prices to go into the general market so that you have a chance to get them." a. What does he mean by the “general market"? b. Suppose that ticket bots were eliminated, and theaters were able to enforce a limit of each person being allowed to buy only four tickets. Is it likely that most of the people attending a hit Broadway musical like Hamilton would pay face value for their tickets? Briefly explain.

In a forbes.com column, Patrick Rishe, an economist at Washington University, noted that in recent years, the National Football League has significantly expanded the number of games it broadcasts. As a result, he argued: "The NFL has oversaturated the market with its product.... TV ratings, consequently, have fallen. At least in part, diminishing marginal utility is a likely explanation as to why." Briefly explain his reasoning.

Considering only the income effect, if the price of an inferior good declines, would a consumer want to buy a larger quantity or a smaller quantity of the good? Does your answer mean that the demand curves for inferior goods should slope upward? Briefly explain.

Someone who owns a townhouse wrote to a real estate advice columnist to ask whether he should sell his townhouse or wait and sell it in the future, when he hoped that prices would be higher. The columnist replied: "Ask yourself: Would you buy this townhouse today as an investment? Because every day you don't sell it, you're buying it." Do you agree with the columnist? In what sense are you buying something if you don't sell it? Should the owner's decision about whether to sell depend on what price he originally paid for the townhouse?

Define behavioral economics. What are the three common mistakes that consumers often make? Give an example of each mistake.
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