The nature of the income effect of a price change depends on whether the good is normal or inferior. The income effect reinforces the substitution effect in the case of normal goods; it works in the opposite direction for inferior goods.
A normal good is one whose consumption increases with an increase in income. When the price of a normal good falls, there are two identifying effects:
In the case of a normal good, then, the substitution and income effects reinforce each other. Ms. Andrews's response to a price reduction for apples is a typical response to a lower price for a normal good.
An increase in the price of a normal good works in an equivalent fashion. The higher price causes consumers to substitute more of other goods, whose prices are now relatively lower. The substitution effect thus reduces the quantity demanded. The higher price also reduces purchasing power, causing consumers to reduce consumption of the good via the income effect.
In the chapter that introduced the model of demand and supply, we saw that an inferior good is one for which demand falls when income rises. It is likely to be a good that people do not really like very much. When incomes are low, people consume the inferior good because it is what they can afford. As their incomes rise and they can afford something they like better, they consume less of the inferior good. When the price of an inferior good falls, two things happen:
The case of inferior goods is thus quite different from that of normal goods. The income effect of a price change works in a direction opposite to that of the substitution effect in the case of an inferior good, whereas it reinforces the substitution effect in the case of a normal good.
Figure 7.5 Substitution and Income Effects for Inferior Goods
The substitution and income effects work against each other in the case of inferior goods. The consumer begins at point A, consuming q1 units of the good at a price P1. When the price falls to P2, the consumer moves to point B, increasing quantity demanded to q2. The substitution effect increases quantity demanded to qs, but the income effect reduces it from qs to q2.
Figure 7.5 "Substitution and Income Effects for Inferior Goods" illustrates the substitution and income effects of a price reduction for an inferior good. When the price falls from P1 to P2, the quantity demanded by a consumer increases from q1 to q2. The substitution effect increases quantity demanded from q1 to qs. But the income effect reduces quantity demanded from qs to q2; the substitution effect is stronger than the income effect. The result is consistent with the law of demand: A reduction in price increases the quantity demanded. The quantity demanded is smaller, however, than it would be if the good were normal. Inferior goods are therefore likely to have less elastic demand than normal goods.