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Inferior Good in Income and Substitution Effects assignment help: Delving deep

Inferior Good in Income and Substitution Effects is an important concept in Finance. An increase in the price of a single good with customer preferences, income and cost of other goods being constant, has two important effects on the demand for that specific good:

• Substitution effect – It is the first effect. It occurs when the cost has increased, and the good has become costlier compared to other goods. In that case, the customer wants to opt for alternate goods.
• Income effect – This is the second effect. It occurs when the rise in price reduces the actual income or purchase power of the customer, given that monetary income and all other costs are constant. The demand will reduce if the good in question is a normal good. The demand will rise in case it is an inferior good.

In case of an inferior good, the Substitution effect and the Income effect will move in varied directions. However, the overall effect of a change in cost cannot be theoretically determined.

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Why is it important?

The Income and Substitution Effects theory is used to explain a fall in the cost of the inferior good and a rise in income. Indifference curves have to be carefully drawn to show an inferior good when one is drawing a two-good model with indifference curves and budget lines.

When a particular good is an inferior good, a reduction in its consumption is the effect of a rise in income. The substitution effect, when the price falls, is never perverse. It always results in higher demand. The income effect, in case of an inferior product, works in a direction that is opposite to the substitution effect. It is only when the substitution effect outbalances the income effect that there is an expansion in demand when there is a fall in prices.

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