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Income and Substitution Effect

Posted: Monday, 18 August, 2014. | By: Equipoise Bot

Definition
The income effect is the change in consumption patterns due to the change in purchasing power and the substitution effect is the change in consumption patterns due to a change in the relative prices of goods. 
Example
Consider two goods A and B. Two cases are explained below with normal and inferior good (An inferior good is a good that decreases in demand when consumer income rises).
Case 1:  Increase in the price of Good A.

A Normal, B Normal

A Normal, B Inferior

 

Consumption
Good A

Consumption
Good B

 

Consumption
Good A

Consumption
Good B

Substitution Effect

-

+

Substitution Effect

-

+

Income effect

-

-

Income effect

-

+

Net Effect

-

?

Net Effect

-

+

Assuming that the substitution effect is stronger than the income effect, an increase in the price of good A will result in a net effect of decrease in consumption of A, and an increase in consumption of good B

The substitution effect makes B relatively cheaper, so consumption of B will increase, and consumption of A will decrease. The income effect makes the buyer feel poorer, and so consumption of A will decrease, but consumption of B will increase.

 

Case 2: Decline in the price of Good A

 

A Normal, B Normal

A Normal, B Inferior

 

Consumption
Good A

Consumption
Good B

 

Consumption
Good A

Consumption
Good B

Substitution Effect

+

-

Substitution Effect

+

-

Income effect

+

+

Income effect

+

-

Net Effect

+

?

Net Effect

+

-

The substitution effect will cause higher consumption of A and lower consumption of B.  Income effect would increase the consumption of both the goods. Net effect would depend on the stronger of the two effects.

The substitution effect will cause higher consumption of A and lower consumption of B, and the income effect will cause higher consumption of A and lower consumption of B. Because the buyer now feels richer, they are less inclined to buy the inferior good.


Giffen good
Giffen goods are those for which an increase in price causes an increase in demand. This results in an upward-sloping demand curve. This may be because people might associate higher prices with status, luxury, and quality, and a higher price might increase the perceived value of a good. Also if a good is inferior and the income effect outweighs the substitution effect, case of Giffen goods arise.

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