Suppose there are only two normal goods in the economy, X and Y. If price of good X increases, which would be the correct statement from below?
- (a)Demand for good X decreases and demand for Y is indeterminate.
- (b)Demand for good X decreases and demand for Y decreases.
- (c)Demand for good X increases and demand for Y is indeterminate.
- (d)Demand for good X increases and demand for Y decreases.
Correct — A, Demand for good X decreases and demand for Y is indeterminate. The first half is the law of demand: X has become dearer, so less of it is bought. The second half needs the two effects to be separated. The substitution effect pushes consumers away from the now dearer X and towards Y, raising demand for Y. But the price rise also lowers real income, and because Y is a normal good, lower real income reduces demand for Y. The two effects work in opposite directions and the net result depends on which is stronger, so nothing definite can be said about Y from the information given. That is precisely why the answer is worded as indeterminate: goods that are gross substitutes will show a rise in Y, goods that are gross complements a fall, and the question tells us only that both are normal, not how they relate to each other.
- (b)Demand for good X decreases and demand for Y decreases. — Gets X right but asserts a definite fall in Y. That happens only if the income effect outweighs the substitution effect, which the question does not tell us.
- (c)Demand for good X increases and demand for Y is indeterminate. — Has X rising with its own price, which would require X to be a Giffen good — impossible here, since the question says both goods are normal.
- (d)Demand for good X increases and demand for Y decreases. — Wrong on both counts, and the first half again contradicts the law of demand for a normal good.
A price change acts on demand through two channels. The substitution effect is the change in consumption when relative prices change with real income held constant; it always moves consumption away from the good that has become relatively dearer. The income effect is the change that follows from the loss of purchasing power; for a normal good it moves in the same direction as real income. For the good whose own price rose, both effects point the same way, so demand certainly falls. For the other good the two effects conflict.
The question is a test of whether the two effects are held apart in the mind. Many candidates answer that Y must rise, reasoning only through substitution; others answer that Y must fall, reasoning only through the loss of real income. Both are half-arguments. The word 'normal' in the stem is doing two jobs — it rules out the Giffen case for X, and it fixes the sign of the income effect for Y so that the conflict is genuine.
- Total effect of a price change = substitution effect + income effect.
- For a normal good the income effect reinforces the substitution effect, so the demand curve slopes downward.
- For an inferior good the two effects oppose; a Giffen good is the extreme case where the income effect wins and demand rises with price.
- Two goods are gross substitutes if a rise in the price of one raises demand for the other, and gross complements if it lowers demand for the other.
- Answering that Y must rise because consumers switch to it — that is only the substitution effect.
- Forgetting that the income effect operates even though money income has not changed; it is real income that falls.
- Assuming any two goods in a two-good model must be substitutes.
As a reasoning item on what happens to the other good when one price rises, or as a direct question on the income and substitution effects for normal, inferior and Giffen goods.
No directly related past PYQ was found.
- practice — not a real PYQ
For a Giffen good, a rise in price leads to
- (a)a fall in quantity demanded
- (b)a rise in quantity demanded
- (c)no change in quantity demanded
- (d)a rise in supply only
Answer(b) a rise in quantity demanded — the negative income effect outweighs the substitution effect, so the demand curve slopes upward.
- practice — not a real PYQ
The substitution effect of a rise in the price of a good always
- (a)increases the quantity demanded of that good
- (b)reduces the quantity demanded of that good
- (c)leaves quantity demanded unchanged
- (d)depends on whether the good is normal or inferior
Answer(b) reduces the quantity demanded of that good — the substitution effect is unambiguously negative; only the income effect depends on whether the good is normal or inferior.