Question

Income effects depend on the income elasticity of demand for each good that you buy. If one of the goods you buy has a negative income elasticity, that is, it is an inferior good, what must be true of the income elasticity of the other good you buy?

Short answer

In conclusion, if one of the goods a consumer buys is an inferior good with a negative income elasticity of demand (\(\eta_1 < 0\)), the other good must have a positive income elasticity of demand (\(\eta_2 > 0\)), making it a normal good.

Step-by-step solution

Definition of Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in a consumer's income, holding all other factors constant. It is calculated as the percentage change in the quantity demanded of the good divided by the percentage change in income.

Inferior and Normal goods

An inferior good is a good for which the quantity demanded decreases as income increases (i.e., it has a negative income elasticity of demand). A normal good is a good for which the quantity demanded increases as income increases (i.e., it has a positive income elasticity of demand).

Assumption: Two goods

We assume that the consumer only buys two goods. Let's denote income elasticity of demand for Good 1 as \(\eta_1\) and for Good 2 as \(\eta_2\). It is given that Good 1 is an inferior good i.e., \(\eta_1 < 0\).

What must be true of the income elasticity of the other good?

In order for the consumer to still spend their entire income despite the decrease in quantity demanded of the inferior good (Good 1) due to an increase in income, the quantity demanded of the other good (Good 2) must increase with the increase in income. Thus, Good 2 must be a normal good with a positive income elasticity of demand, meaning \(\eta_2 > 0\). In conclusion, if one of the goods a consumer buys is an inferior good with a negative income elasticity of demand, the other good must have a positive income elasticity of demand, making it a normal good.

Key concepts

Inferior Good

An inferior good is an interesting concept in the realm of economics, particularly when discussing consumer choices and behaviors. It refers to a good for which demand decreases as consumer income increases. This inverse relationship is fascinating because it goes against the intuitive notion that higher income leads to an increase in the purchase of most goods.

Imagine having a tight budget and mostly buying instant noodles because they are affordable. As your income grows, you start to opt for fresh ingredients or dine at restaurants instead. The instant noodles in this scenario are considered an inferior good. The income elasticity of demand for such goods is negative, indicating that as consumers' incomes rise, they tend to purchase less of these goods. Economics isn't just about numbers; it's also about human behavior and preferences which are evident in the categorization of products like inferior goods.

Normal Good

In stark contrast to inferior goods, we have normal goods, which align more closely with what people expect to happen as their income increases. A normal good sees a rise in quantity demanded as consumer income grows. The more money people have, the more they are willing and able to buy products and services that improve their quality of life.

For example, think about someone upgrading their smartphone to the latest model when they get a better-paying job. This is a typical behavior associated with normal goods. The income elasticity of demand for normal goods is positive, confirming that as consumers' disposable income climbs, they often pursue higher-quality goods or those that bring more satisfaction, thereby increasing their consumption of such goods.

Consumer Income

Consumer income is the lifeblood of market economies, governing much of the demand side of economic transactions. It's the total earnings received by consumers, which include wages, salaries, pensions, and investment dividends. Changes in consumer income affect not only individual purchasing power but also dictate overall market demand for goods and services.

If consumers experience an increase in income, they generally expand their spending on assorted goods, although the pattern of this spending heavily depends on whether the goods are considered normal or inferior. Understanding the relationship between consumer income and spending behavior is essential for businesses and policy-makers as they anticipate market trends and make informed decisions.

Quantity Demanded

The term 'quantity demanded' refers to the total amount of a good or service that consumers are willing and able to purchase at a given price, within a specified period. It's vital to note that quantity demanded is not the same as the demand itself, which is the overall relationship between price and the quantity demanded. It is, instead, the specific point on the demand curve at a particular price.

Various factors influence the quantity demanded, with price being the most direct one. However, changes in consumer income, which affect consumers' purchasing power, have a substantial influence as well. As incomes increase, for instance, the quantity demanded for normal goods will tend to increase, reflecting the consumer's ability to afford more items or higher-quality alternatives. Conversely, for inferior goods, the quantity demanded reacts in the opposite direction when consumer incomes rise.