Suppose the price of potatoes falls and we observe a decrease in an individual's purchases of potatoes. Which of the following can we infer?
A) The income effect is negative and reinforces the substitution effect.
B) The income effect is positive and exceeds the substitution effect.
C) The income effect just offsets the substitution effect.
D) The substitution effect outweighs the income effect.
E) The income effect is negative and outweighs the substitution effect.

Question

Quizplus · Accepted Answer

The decrease in the price of potatoes causes an increase in the purchasing power of the individual's income, which leads to a positive income effect. However, the decrease in price also makes potatoes relatively cheaper compared to other goods, leading to a substitution effect towards other goods. Since the individual's purchases of potatoes have decreased, the income effect is negative and outweighs the substitution effect. Therefore, the best choice is E.

Suppose the Price of Potatoes Falls and We Observe a Decrease