ap economy question

Question

Which of the following statements is true? (answer is b but please explain why)

a) Normal goods and inferior goods differ in regard to the direction of the substitution effect caused by a price increase.

b) In the case of an inferior good, the income and substitution effects work in opposite directions.

c) In the case of an inferior good, the income effect is usually larger than the substitution effect.

d) A change in consumption brought about by a change in purchasing power describes the substitution effect.

e) When a good absorbs only a small share of the typical consumer’s income, the income effect explains the demand curve’s negative slope.

Answer 1

For ease of exposition, let's assume that there are two goods (x and y), and the price of good x has increased.

For all goods, the substitution effect of a price increase is negative. That is, holding purchasing power constant, the consumer will substitute to consume less of good x (and more of good y) after the increase in the price of good x.

In terms of the income effect, a price increase is like a decrease in income (the consumer can't afford to purchase as many goods as before). For an inferior good, this decrease in income causes consumption to increase, so the income effect is positive.