Inferior Goods: Income & Substitution Effects

Income & Substitution Effects of Inferior Goods

Inferior goods are those goods whose demand decreases with the increase in the income of the consumers. For example, bajra. If the income of the consumer increases, then he substitutes the inferior good with that of the normal good. So this decreases the consumption of inferior goods and increases the consumption of normal goods.

Suppose a consumer consumes two goods, X and Y, where X is an inferior good. The income and substitution effects of a fall in the price of X are illustrated in the following diagram:

Suppose that the consumer is in equilibrium at point P, where the budget line M₁N₁ is tangent to the indifference curve IC₁. Now, if the price of X falls, other factors remain the same, the budget line shifts to M₁N_3, and the consumer moves from equilibrium point P to R. The movement from P to R is the price effect.

To eliminate the income effect of the price change, let us draw, following the Hicksian method, a compensatory budget line M₂N₂ which is tangent to the original indifference curve IC₁ at point Q. The consumer’s movement from P to Q means an increase by X₁X₃ in the quantity consumed of X. This is the substitution effect, which results from a fall in the price of X.

Note that the substitution effect of a fall in the price of an inferior good (X) is very powerful. It is so powerful that the substitution effect X₁X₃ exceeds the total price effect X₁X₂. This makes the income effect of a change in the price of an inferior good negative.

The movement from Q to R shows the negative income effect, that is, a decrease in the quantity of X demanded, where,

IE = PE – SE

IE = X₁X₂ – X₁X₃ = – X₂X₃

Thus, while the income effect of a fall in the price of an inferior good causes a decrease in the consumption of the good, the substitution effect increases its quantity demanded, i.e. the income and substitution effects work in opposite directions in the case of an inferior good.

Here it is important to note that since inferior goods show a relation between the income of the consumer and the quantity of the inferior good therefore, we can derive an Engel curve in this case; the demand curve cannot be derived as demand shows a relationship between price and quantity.

Moreover, since an inferior good has an inverse relationship with income, therefore, the Engel curve for inferior goods will be downward sloping.

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