The following can be said about the income and substitution effects of a price increase on the demand for a good whose price rose:

A) The former is always positive and the latter is always negative.
B) Both can be either positive or negative.
C) While the latter is always negative, the former can be either positive or negative.
D) While the former is always negative, the latter can be either positive or negative.
E) The former can at times be negative, but it will never overwhelm the latter.

Question

Rawan Almutairy · Accepted Answer

Final Answer : C, Explanation :  The income effect is the change in quantity demanded due to a change in purchasing power resulting from a price change, and it always depends on whether the good is normal or inferior. If the good is normal, then a price increase leads to a decrease in the quantity demanded, resulting in a negative income effect. If the good is inferior, then a price increase leads to an increase in the quantity demanded due to the perception of the good becoming relatively cheaper, resulting in a positive income effect. On the other hand, the substitution effect is the change in quantity demanded due to a change in the relative price of the good compared with other goods, and it's always negative since the increase in the price of the good makes it relatively more expensive than other goods, decreasing the quantity demanded. Therefore, while the substitution effect is always negative, the income effect can be either positive or negative, depending on whether the good is normal or inferior.

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