How Do Income and Substitution Effects Work on Consumer’s Equilibrium for Giffen, Normal and Inferior Goods?
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 X1X3. This is because of the substitution effect alone.
Thus, income effect = X2X1 - X1X3, 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:
Type of Good
Inferior (but not Giffen)
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