How Do Income and Substitution Effects Work on Consumer’s Equilibrium for Giffen, Normal and Inferior Goods?

Updated on May 31, 2014

Giffen Goods Explanation

While all normal goods and many of the inferior goods obey law of demand, which states that more quantities of commodities are demanded at less prices, there are certain inferior goods that do not follow the law of demand. Such type of commodities are termed as Giffen Goods. In case of Giffen goods, there is a positive relationship between price and quantity demanded. Not all inferior goods are Giffen goods. However, Giffen goods are inferior goods. This type of commodities are named after a renowned British statistician and economist called Sir Robert Giffen. In case of Giffen goods, when price increases, its quantity demanded also increases.

Giffen’s observation attributes that very poor workers increase their consumption of cheap food like bread, when its price increased. He claims that according to his study, the workers spent large portions of their income on bread when its price increased. The reason behind this is that they were unable to afford expensive foods such as meat because their prices also increased. Since large portion of income was spent on bread (the cheapest food available), the workers were unable to buy expensive foods. Therefore, consumption of bread increased even when its price increased. This scenario causes a paradoxical situation and this paradox is popularly known as Giffen paradox.

Income and Substitution Effects on Giffen Goods

In figure 1, the consumer’s initial equilibrium point is E1, where original budget line M1N1 is tangent to the indifference curve IC1 . X-axis represent Giffen goods (commodity X) and Y-axis denotes superior goods (commodity Y). Assume that price of Giffen goods decreases. This causes the budget line to shift outward and forms a new budget line M1N3. The consumer moves to the new equilibrium point E3. At this new equilibrium point the quantity demanded of commodity X decreases by X2X1. This movement represents the total price effect. Total price effect consists of income effect and substitution effect. By drawing a parallel budget line M2N2, we are eliminating the income effect. Hence, the consumer again moves to another equilibrium point E2. At E2, the quantity demanded of commodity X increases by X13. This is because of the substitution effect alone.

Thus, income effect = X2X1 - X13, which must be negative. Furthermore, the substitution effect is positive. In this way, the income effect and substitution effect work in the opposite direction in case of Giffen goods.

However, in the modern economy, it is difficult to find an example for Giffen paradox. Furthermore, many economists are not ready to believe that Giffen paradox was actually observed. Hence, with little empirical evidence it is plausible to conclude that the Giffen paradox in real life is very unlikely.

Income and Substitution Effects on Normal Goods

Normal goods, as the name indicate, are goods that we use in our day-to-day life. People tend to use more of normal goods when as income increases.

Let us see what figure 2 depicts. The consumer’s original equilibrium is E1. At this point, the budget line M1N1 is tangent to the indifference curve IC1. Suppose the price of commodity X (normal goods) decreases and other things remain the same. The price decline shifts the budget line to M1N3. Consequently, the consumer moves to new equilibrium point E3. Consumer’s movement from E1 to E3 is the total price effect. Let us eliminate the income effect from the price effect by following Hicks’ version. To do so, we draw an imaginary budget line M2N2, which is tangent to IC1 at E2. E2 equilibrium point after the elimination of the income effect.

Hence, total price effect = X1X3

Substitution effect = X1X2

Income effect =X2X3

Income and Substitution Effects on Inferior Goods

Inferior goods are cheap alternatives for normal goods. People use inferior goods when they are unable to afford normal goods or expensive goods. Therefore, consumption of inferior goods by a person decreases if income increases above a certain level. This implies that inferior goods have strong positive substitution effect. However, when the price of an inferior good falls, the consequence will be an increase in the quantity demanded because of significant negative income effect.

In figure 3, X-axis represents inferior goods (commodity X) and Y-axis denotes superior goods (commodity Y). The consumer’s original equilibrium point is E1. At this equilibrium point, the budget line M1N1 is tangent to indifference curve IC1. If price of commodity X is reduced, new budget line M1N2 is formed and the consumer moves to the new equilibrium point E2. At E2, the budget line M1N2 is tangent to indifference curve IC2. Here, consumer’s movement from equilibrium point E1 to equilibrium point E2 is the total price effect. We follow Hicks’ version to eliminate the income effect from the price effect. To accomplish this, an imaginary budget line M2N3 is drawn in such a way that it is parallel to budget line M1N2 and tangent to the original indifference curve IC1 at E3. Hence, E3 is the equilibrium point after the elimination of income effect.

Here, total price effect = X1X2

Substitution effect = X1X3

Thus, income effect = total price effect – substitution effect

i.e., income effect = X1X2 - X1X3= - X2X3

Thus, in case of inferior goods, the positive substitution effect (X1X3) is stronger than the negative income effect (X2X3). This implies that many of the inferior goods obey the law of demand.

The following table shows substitution and income effects of a price decline on quantity demanded of different types of commodities:

Table 1

Type of Good
Substitution Effect
Income Effect
Total Effect
Normal
Increase
Increase
Increase
Inferior (but not Giffen)
Increase
Decrease
Increase
Giffen
Increase
Decrease
Decrease

© 2013 Sundaram Ponnusamy

Comments

    0 of 8192 characters used
    Post Comment

    • profile image

      Tochukwu 

      5 weeks ago

      Thank you for the simplification. Many students struggle to understand income and substitution effects of price changes.

    • profile image

      Ramsha Irshad 

      4 years ago

      this is very excellent....metrial is to tha point which is best part

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, owlcation.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://owlcation.com/privacy-policy#gdpr

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)