Suppose that macaroni and cheese is an inferior good and the price of macaroni and cheese rises. Explain the income and substitution effects of this price change
What will be an ideal response?
When the price of macaroni and cheese rises, we have less purchasing power than before. If macaroni and cheese is an inferior good, this means that we will consume more of it. This is the income effect. Also, an increase in the price of macaroni and cheese makes it relatively more expensive. Thus, households will shift away from purchasing macaroni and cheese to purchase relatively cheaper goods. This is the substitution effect. Because these two effects work in opposite directions, the outcome (in terms of the quantity of macaroni and cheese demanded) will depend on which effect is larger. While it is theoretically possible, it is unlikely for this income effect to be larger than the substitution effect.
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