Assume that a consumer has well-behaved preferences. Following a price increase for good 1, we observe that a consumer increases the quantity demanded for good 1. From this, we know that

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When the price of good 1 rises and the consumer ends up buying more of good 1, the situation requires unpacking the two effects that the price change generates: the substitution effect and the income effect. 
Option 1: 'Good 1 must be an inferior good.' This follows from the standard decomposition: a price increase lowers real purchasing power (income effect), and for quantity to rise, the income effect must move demand upward. The only way for the overall quantity to rise while the substitution effect pulls it downward is if the income effect is positive and dominates, which characterizes an inferior good. In other words, with a well-behaved (monotone, convex) preferences setup, a Giffen-type situation can occur where the inferior good’s demand increases as its price rises. 
Option 2: 'The pure substitution effect and the income effect must reinforce one another.' This cannot be correct in this context. The substitution effect, holding utility constant, always responds to a price rise by reducing quantity demanded of the good (for a normal upward-sloping or typical convex indifference curve setup, the substitution effect moves you along a compensated demand to less of the good). Since the observed outcome is an increase in quantity, the two effects cannot be reinforcing in this direction; at least one of them would have to push quantity upward, which is not the case for the pure substitution effect alone. 
Option 3: 'None of the other options is correct.' If the observed outcome is truly a rise in quantity after a price increase, it would be explained by the inferior (Giffen) scenario described in Option 1. Therefore, dismissing all other options as incorrect would ignore a valid interpretation under standard microeconomic theory. 
Option 4: 'The pure substitution effect increases the consumption of good 1.' The substitution effect, as noted, moves in the opposite direction to the observed total change when the price goes up: it would decrease consumption of the good, not increase it. Thus this statement misstates the direction of the substitution effect in response to a price rise.

ECON5001 Microeconomic Theory Quiz 2 (available 1 April, due 11 April)

Assume that a consumer has well-behaved preferences. Following a price increase for good 1, we observe that a consumer increases the quantity demanded for good 1. From this, we know that

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ECON5001 Microeconomic Theory Quiz 2 (available 1 April, due 11 April)

Assume that a consumer has well-behaved preferences. Following a price increase for good 1, we observe that a consumer increases the quantity demanded for good 1. From this, we know that

View Explanation

Log in for full answers

Similar Questions

Sarah usually buys 5 cups of coffee and 2 muffins every day. The price of coffee falls significantly. Explain how the substitution effect and the income effect influence Sarah’s decision to buy more coffee.

For Sarah, meals at McDonald’s are an inferior good. When the price of meals at McDonald’s increases, Sarah buys less McDonald’s meals. This means that:

If a good is normal and its price increases,

Which of the following occurs simultaneously with an income effect?

Rose is allocating her budget between two goods—Apples and Bananas; both are normal goods. If the price of apples increases from $1 per pound to $2 per pound, then the income effect causes her to buy ___of apples and the substitution effect causes her to buy___ of apples.

The effect of a change in relative price on consumer choice can be divided into:

Which of the following occurs simultaneously with an income effect?

Consider a consumer buying perfect complements. If there is a decrease in the price of good 1, the total change in consumption of good 1 is due to

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

Rose is allocating her budget between two goods—Apples and Bananas; both are normal goods. If the price of apples increases from $1 per pound to $2 per pound, then the income effect causes her to buy _of apples and the substitution effect causes her to buy_ of apples.