Questions: Income and Substitution Effects of Price Changes

Question 1

When the price of an inferior good falls, which of the following correctly describes the two effects?

• A. Both the substitution and income effects increase quantity demanded
• B. The substitution effect increases quantity demanded; the income effect decreases it
• C. The substitution effect decreases quantity demanded; the income effect increases it
• D. Both the substitution and income effects decrease quantity demanded

Answer: (B)

The substitution effect always moves opposite to the price change — a price fall makes the good relatively cheaper, so consumers substitute toward it, increasing quantity demanded. But a price fall also raises real purchasing power. For an inferior good, feeling richer leads consumers to buy less of it (they prefer something better). So the income effect pulls in the opposite direction from the substitution effect. For a normal good, both effects would reinforce each other.

Question 2

A student explains that when coffee's price falls, they buy more because 'holding utility constant, coffee is now relatively cheaper than tea.' This explanation captures:

• A. The total effect of the price change
• B. Only the income effect
• C. Only the substitution effect
• D. Neither effect — relative price changes are not relevant to consumer choice

Answer: (C)

The substitution effect is defined as the change in quantity demanded when real welfare is held constant but the consumer faces the new relative prices. 'Holding utility constant, coffee is now relatively cheaper than tea' describes exactly this: no change in wellbeing, but a rearrangement driven by changed relative prices. The income effect is the separate component that asks: how does behavior change because real purchasing power has changed?

Question 3

The substitution effect can push quantity demanded in either direction depending on whether a good is normal or inferior.

• T. True
• F. False

Answer: False

The substitution effect always moves opposite to the price change, regardless of whether the good is normal or inferior. When price falls, the substitution effect always increases quantity demanded; when price rises, the substitution effect always decreases it. It is the income effect whose direction depends on good type — positive for normal goods, negative for inferior goods.

Question 4

A Giffen good is a special case of an inferior good where the income effect is strong enough to overwhelm the substitution effect.

• T. True
• F. False

Answer: True

Correct. For a Giffen good, the price rise reduces real purchasing power (income effect), and because the good is strongly inferior, this causes the consumer to buy more of it — enough to outweigh the always-present substitution effect pushing in the opposite direction. The result is a demand curve that slopes upward: quantity demanded rises when price rises. Giffen goods are theoretically possible but extremely rare in practice.

Question 5

Explain why the substitution effect always moves in the opposite direction from a price change, regardless of whether the good is normal or inferior.

Model answer: The substitution effect is defined as the behavioral change when real utility is held constant but relative prices shift. When a good's price falls, it becomes cheaper relative to all other goods. Even if you were somehow kept at the same level of well-being, you would rearrange your consumption to buy more of the now-cheaper good and less of relatively more expensive alternatives. This logic holds regardless of income level or good type — it is purely a response to the change in relative prices.

The key is the definition: the substitution effect is isolated by asking 'what would you do if prices changed but your utility level stayed the same?' Relative price changes always create an incentive to substitute toward the cheaper good and away from relatively more expensive goods. The normal/inferior distinction only matters for the income effect — which asks what happens when real purchasing power changes.