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Indifference Curves and Demand for Inferior Goods

Consider, for an inferior good, the relationship between indifference curves, budget lines, price changes and demand curves. [13]

Category:

Consumer Theory and Demand Analysis

[CIE A level March 2019]

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Answer

Tip : One of the keywords here is inferior goods. It is important to write this essay in relation to inferior goods. Include clear and well labelled diagrams.


Step ➊ : Define 'indifference curves, budget lines and inferior goods' in the introduction.


Indifference curves and budget lines can be used to explain the effect of price changes and income changes of inferior goods. An inferior good is a good whose demand drops when people's incomes rise. Consumers maximise satisfaction and determine demand by relating utility to price; this is shown by indifference curves and budget lines. An indifference curve shows all the various combinations of two goods that give an equal amount of satisfaction or utility to a consumer. The budget line shows what combinations of two goods an individual is able to buy, given the income available to spend on them and their prices. In this essay, we will discuss the relationship between indifference curves, budget lines, price changes and demand curves for inferior goods.


Step ➋ : Explain the income and substitution effects of price change for inferior goods.


➤ 2.1 An increase in income is represented by a parallel shift outwards of the budget line. This will then lead to a new optimum consumption point on a higher indifference curve. This can be shown in the figure below.

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Assume, X were an inferior good, such as cheap margarine, its demand would fall as income rises; its income elasticity of demand would be negative. This is illustrated in the figure above. Point b is to the left of point a, showing that at the higher income B2, less X is purchased.

Conversely, a fall in income is represented by a parallel shift inwards of the budget line. This will then lead to a new optimum consumption point on a lower indifference curve.

When people’s incomes rise, they will buy less of inferior goods such as poor-quality margarine and cheap coffee, since they will now be able to afford better-quality goods instead. Conversely, when their income falls, they will have to reduce their living standards. Their consumption of inferior goods will consequently rise.

➤ 2.2 A change in price for an inferior good will cause the budget line to pivot. This is shown in the figure below.

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➤ 2.1 The substitution effect.

If the price of an inferior good (good X) rises, the substitution effect will be negative. People will consume less X relative to Y, since X is now more expensive relative to Y. This is illustrated in the figure above by a movement along the original indifference curve (I1) from point f to point g. The quantity of X demanded falls from QX1 to QX2.

➤ 2.2 The income effect.

The income effect of the price rise will be positive for an inferior good. The reduction in real income from the rise in the price of X will tend to increase the consumption of X, since with a fall in real income more inferior goods will now be purchased – including more X. Thus point h is to the right of point g: the income effect increases quantity back from QX2 to QX3.

➤2.3 The overall effect

If the price rises for an inferior good it causes a fall in demand because of the substitution effect but a rise in demand because of the income effect. The overall result is still a fall in demand.

Conversely, If the price falls for an inferior good it causes a rise in demand because of the substitution effect but a fall in demand because of the income effect. The overall result is still an increase in demand, but a smaller increase than if the good were a normal good.

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Step ➌ : Conclude
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To conclude, theory states that consumers maximise satisfaction and determine demand by relating utility to price; this is shown by indifference curves and budget lines. Any income change would shift the budget lines in a parallel manner, a price change of one good would cause the budget line to pivot. Either would cause the consumer’s equilibrium position to change – the extent and direction of the change would depend on the type of good.

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♕ Marking scheme
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Theory states that consumers maximise satisfaction and determine demand by relating utility to price; this is shown by indifference curves and budget lines. Income changes shift budget lines parallel, price change of one good cause budget line to pivot. Equilibrium is changed – the extent and direction depending on the type of good. Explanation of income and substitution effects for an inferior good.

L4 (9–13 marks): for a clear explanation of the links and correct analysis of income and substitution effects of price change.

L3 (7–8 marks): for a briefer explanation; no clear link to the demand curve, or link to demand but some confusion over income and substitution.

L2 (5–6 marks): for a poor explanation of the terms or a weak comment on the links.

L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory.

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♕ Examiner’s report
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The theory states that consumers maximise satisfaction and determine demand by relating utility to price; this is shown by indifference curves and budget lines. Any income change would shift the budget lines in a parallel manner, a price change of one good would cause the budget line to pivot. Either would cause the consumer’s equilibrium position to change – the extent and direction of the change would depend on the type of good. It was necessary, in answering this question, to explain the income and substitution effects for an inferior good. Candidates sometimes confused the negative income effect for an inferior good caused by a rise in income with the overall effect of a price change. If the price falls for an inferior good it causes a rise in demand because of the substitution effect but a fall in demand because of the income effect. The overall result is still an increase in demand, but a smaller increase than if the good were a normal good. Many candidates stated that there would be an overall fall in demand. It is only with Giffen goods that the overall effect results in a lower demand. Most candidates who answered this question used a diagram which they hoped would illustrate their answer. Sadly, many of the diagrams were very small or badly drawn and did not achieve that hope.

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