Introduction

When the price of q1, p1, changes there are two effects on the consumer. First, the price of q 1

relative to the other products (q2, q3, . . . qn) has changed. Second, due to the change in p 1, the

consumer's real income changes. When we compute the change in the optimal consumption as a

result of the price change, we do not usually separate these two effects. Sometimes we might

want to separate the effects.

The Substitution Effect is the effect due only to the relative price change, controlling for the

change in real income. In order to compute it we ask what is the bundle that would make the

consumer just as happy as before the price change, but if they had to make their choice faced

with the new prices. To find this point we consider a budget line characterized by the new prices

but with a level of income such that it is tangent to the initial indifference curve. In the diagram

on the next page, the initial consumer equilibrium is at point A where the initial budget line is

tangent to the higher indifference curve. Consumption at this point is 11 units of good 1 and 8

units of good 2. After an increase in the price of good 1, the consumer moves to point E, where

the new budget line is tangent to the lower indifference curve. Consumption of good 1 has fallen

to 4 units while consumption of good 2 has increased to 10 units. The substitution effect is the

movement from point A to point G. This point is characterized by two things. (1) It is on the

same indifference curve as the original consumption bundle; AND (2) it is the point where a

budget line that is parallel to the new budget line is just tangent to initial indifference curve. This

"intermediate" budget line is attempting to hold real income fixed so we can isolate the

substitution effect. The point G reflects the consumer's choice if faced with the new prices (the

budget line has the slope reflecting the new prices) and the compensated income ( i.e., an income

level that holds real income fixed). The substitution effect is the difference between the original

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consumption and the new "intermediate" consumption. In this case consumption of good 1 falls

from 11 to 6.84 while consumption of good 2 increases to 14.27.

When p1 goes up the Substitution Effect will always be non-positive (i.e., negative or zero).

The Income Effect is the effect due to the change in real income. For example, when the price

goes up the consumer is not able to buy as many bundles that she could purchase before. This

means that in real terms she has become worse off. The effect is measured as the difference

between the “intermediate" consumption” at G and the final consumption of q1 and q2 at E.

Unlike the Substitution Effect, the Income Effect can be both positive and negative depending on

whether the product is a normal or inferior good. By the way we constructed them, the

Substitution Effect plus the Income Effect equals the total effect of the price change.

Example of Income Effect

Consider a consumer who on an average day buys a cheap cheese sandwich to eat for lunch at

work, but occasionally splurges on a luxurious hot dog. If the price of a cheese sandwich

increases relative to hotdogs, it may make them feel like they cannot afford to splurge on a

hotdog as often because the higher price of their everyday cheese sandwich decreases their real

income.

In this situation, the income effect dominates the substitution effect, and the price increase raises

demand for the cheese sandwich and reduces demand for a substitute normal good, a hotdog,

even if the hotdog's price remains the same.

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Alternative Way of Analyzing a Price Change

One can also analyze the income and substitution effects by first considering the income change

necessary to move the consumer to the new utility level at the initial prices. This constitutes the

income effect. The movement along the new indifference curve from the intermediate point to

the new equilibrium as the slope of the price line changes is then the substitution effect. See if

you can identify the “intermediate” point on the lower indifference curve by shifting the budget

line (Hint: q1 and q2 both fall.).

Substitution and Income Effects

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4
Substitution and Income Effects for an Inferior Good:

The income and substitution effects work in opposite directions for an inferior good. When an

inferior good’s price decreases, the income effect reduces the quantity consumed, whilst the

substitution effect increases the amount consumed. In practice, it has been observed that the

substitution effect is usually larger than the income effect due to the small amount of gross

income allocated by consumers on any given good, and thus the change in demand is usually

insignificant in comparison to the substitution effect (Singh, 2021)

If X is an inferior good, the income effect of a fall in the price of X will be positive because as

the real income of the consumer increases, less quantity of X will be demanded. This is so

because price and quantity demanded move in the same direction On the other hand, the negative

substitution effect will increase the quantity demanded of X.

The negative substitution effect is stronger than the positive income effect in the case of inferior

goods so that the total price effect is negative. It means that when the price of the inferior good

falls, the consumer purchases more of it due to compensating variation in income. The case of X

as an inferior good is illustrated Figure 15.20. Initially, the consumer is in equilibrium at point R

where the budget line PQ is tangent to the curve I1. With the fall in the price of X, he moves to

point T on the budget line PQ1, at the higher indifference curve His movement from R to Tor

from В to E on the horizontal axis is the price effect. By compensating variation in income, he is

in equilibrium at point H on the new budget line MN along the original curve I1 (Kenton, 2021).

The movements from R to H on the I1 curve are the substitution effect measured horizontally by

BD of X. To isolate the income effect, return the increased real income to the consumer which

was taken from him so that he is again at point T of the tangency of PQ; line and the curve l2.

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The movement from H to T is the income effect of the fall in the price of X and is measured by

DE.

This income effect is positive because the fall in the price of the inferior good X leads, via

compensating variation in income, to the decrease in its quantity demanded by DE. When the

relation between price and quantity demanded is direct via compensating variation in income, the

income effect is always positive.

In the case of an inferior good, the negative substitution effect is greater than the positive income

effect so that the total price effect is negative. Thus the price effect (-) BE = (-) BD (substitution

effect) + DE (income effect). In other words, the overall price move from R to T which

comprises both the income and substitution effects has led to the increase in the quantity

demanded by BE after the fall in the price of X. This establishes the downward sloping demand

curve even in the case of an inferior good (Aurthur, 2003).

Also, in the case of an inferior product, the income effect leads to a fall in the quantity

demanded, which will work against the substitution effect. In the following diagram the

substitution effect is Q2 Q5; the income effect is Q5 Q4. However, the substitution effect

outweighs the income effect and overall the quantity demanded rises. The overall change in

quantity demanded results in an increase of Q2 Q4. This means the demand curve is downward-

sloping, because a price fall increases the quantity demanded.

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Substitution and Income Effects for a Giffen Good:

A strongly inferior good is a Giffen good, after Sir Robert Giffen who found that potatoes were

an indispensable food item for the poor peasants of Ireland. He observed that in the famine of

1848, a rise in the price of potatoes led to an increase in their quantity demanded. Thereafter, a

fall in the price led to a reduction in their quantity demanded (Scott, 2010).

This direct relation between price an quantity demanded in relation to essential food items is

called the Giffen paradox. The reason for such a paradoxical tendency is that when the price of

some food articles like bread of mass consumption rises, this is tantamount to a fall in the real

income of the consumers who reduce their expenses on more expensive food items, as a result

the demand for the bread increases. Similarly, a fall in the price of bread raises the real income of

consumers who substitute expensive food item for bread thereby reducing the demand of bread.

In the case of a Giffen good, the positive income effect is stronger than the negative substitution

effect so that the consumer buys less of it when its price falls. This is illustrated in Figure 12.21.

Suppose X is a Giffen good and the initial equilibrium point is R where the budget line PQ is

7
tangent to the indifference curve l1. Now the price of X falls and the consumer moves to point T

of the tangency between the budget line PQ: and the curve I2. His movement from point R to T

is the price effect whereby he reduces his consumption of X by BE.

To isolate the substitution effect, the increased real income due the fall in the price of X is

withdrawn from the consumer by drawling the budget line MN parallel PQ1 and tangent to the

original curve I1 at point H. As a result, he moves from point R to H along the l1 curve. This is

the negative substitution effect which leads him to buy BD more of X with the fall in its price,

real income being constant. To isolate the income effect, when the income that was taken away

from the consumer is returned to him, he moves from point H to T so that he reduces the

consumption of X by a very large quantity DE. This is the positive income effect because with

the fall in the price of the Giffen good X, its quantity demanded is reduced by DE via

compensating variation in income. In other words, it is positive with respect to price change, that

is, the fall in the price of good X leads, via the income effect, to a decrease to the quantity

demanded.

Thus in the case of a Giffen good, the positive income effect is stronger than the negative

substitution effect so that the total price effect is positive. That is why, the demand curve for a

Giffen good has positive slope from left to right upwards. Thus the price effect BE= DE (income

effect) + (-) BD (substitution effect).

According to Hicks, a giffen good must satisfy the following conditions: (i) the consumer must

spend a large part of his income on it; (ii) it must be an inferior good with strong income effect;

and (iii) the substitution effect must be weak. But Giffen goods are very rare which may satisfy

these conditions.

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Furthermore, When a good is inferior and the income effect outweighs the substitution effect, it

is called a Giffen good. This is, however, unlikely, because the substitution effect is almost

always stronger than the income effect.

Substitution and Income Effects for a Normal Good:

For normal goods, the income effect and the substitution effect both work in the same direction;

a decrease in the relative price of the good will increase quantity demanded both because the

9
good is now cheaper than substitute goods, and because the lower price means that consumers

have a greater total purchasing power and can increase their overall consumption.

In the case of a normal good, higher real income leads to an increase in quantity demanded; this

complements the increase due to the substitution effect. This change is shown in the diagram

below.

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