What it is:
An inferior good is a product for which demand goes down as income goes up.
How it works (Example):
As opposed to demand for "normal goods," which goes up as income increases, demand for inferior goods goes down as income increases. Consumers of inferior goods "trade up" to higher priced goods as soon as they can afford it.
Transportation provides a good example. When income is low, it makes sense to ride the bus. But as income increases, people stop riding the bus and start buying cars. It's acceptable to most people to ride the bus when they can't afford a car. But as soon as they can afford one, they buy a car and stop riding the bus. Bus riding declines as income increases.
Rice, potatoes and instant noodles are other examples of inferior goods.
Why it Matters:
As countries increase GDP, their populations eschew inferior goods for normal goods. This is playing out in real time in places like China and India as millions of people leave a subsistence lifestyle and move into the middle class. [See more examples of the changes happening in China and India: 10 Facts About China You Won't Believe (But You Should) and What You Didn't Know About Asia's Next Powerhouse]
Inferior goods are not the same worldwide. Fast food can be considered an inferior good in many western countries, while emerging economies consider it a normal good as they trade up from rice, potatoes, etc.