Question

Suppose there are 2 goods, x1 and x2. The price of x1 goes up. x1 is inferior, and x2 is normal. Using income and substitution effects, show which of the claims below is correct.

Question options:

x1 will decrease in quantity, but x2 will go up

x1 may increase or decrease in quantity, the same is true for x2

the quantity of both goods will go down

the quantity of both goods will go up

Answer 1

Good x1 is inferior. This means that as Income Increases demand for good x1 Decreases and vice versa.

Price of good x1 Increases. Because of Substitution effect at work, since good x1 is more costly now, consumer would Increase Consumption of good x2 now. Thus, according to Substitution effect, Consumer Demand(quantity) for good x1 goes down whereas Demand (quantity) for good x2 increases.

Now, since price of a good increases, the real income of the consumer goes down. Now income effect would be at work. And Due to income effect, quantity of good x1 would Increase as good x1 is inferior and there negative income effect on good x1. But due to income Effect, quantity of good x2 goes down since x2 is normal good because of which there is a positive income Effect.

Quantity of good x1 Decreases due to Substitution effect and Increases due to income effect.

Quantity of good x2 increases due to Substitution effect and decreases due to income effect.

Thus, good x1 may increase or decrease in Quantity depending upon the relative strength of the substitution and income effects. The same is true for good x2.

Therefore, second option is correct.