Substitution and Income Effect

Substitution and Income Effect on Demand

• Substitution Effect - when a product gets cheaper, we substitute and buy more of that product and less of another one.
• Income Effect - when the price of a product falls, it increases your purchasing power, which is like your income is increasing. With that increased purchasing power you can buy more of the same good or some other goods.

Normal Goods

• Let's say the diagram above is for a normal good like books. As the price goes down from $10 to $6, the substitution effect tells us that the quantity demanded will increase from

  4

  ---

  to

  7

  ---

  books.
• As the price of books decreases we also have higher purchasing power. The income effect tells us that we will use this higher purchasing power to buy even more books from

  7

  ---

  to

  9

  ---

  books.
• The total effect would be from 4 to 9 books.
• Normal goods have a

  positive

  ---

  substitution effect and a

  positive

  ---

  income effect

Inferior Goods

• Let's say the diagram above is for an inferior good like hot dogs. As the price goes down from $10 to $6, the substitution effect tells us that the quantity demanded will increase from

  4

  ---

  to

  7

  ---

  hot dogs.
• As the price of hot dogs decrease we also have higher purchasing power. The income effect tells us that we will use this higher purchasing power to buy less hot dogs from

  7

  ---

  to

  5

  ---

  and switch to something higher quality like burgers or pizza.
• The total effect would be from 4 to 5 hot dogs.
• Inferior goods have a

  positive

  ---

  substitution effect and a

  negative

  ---

  income effect, but the positive substitution effect is greater than the negative income effect.

Giffen Goods

• Giffen goods are an extreme case where it is a very inferior good (extremely low quality), which makes the demand upward sloping.
• Let's say the diagram above is for a giffen good like sardines. As the price goes down from $10 to $6, the substitution effect tells us that the quantity demanded will increase from

  4

  ---

  to

  7

  ---

  sardines.
• As the price of sardines decrease we also have higher purchasing power. The income effect tells us that we will use this higher purchasing power to buy less sardines from

  7

  ---

  to

  3

  ---

  and switch to something higher quality like tuna or salmon.
• The total effect would be from 4 to 3 sardines.
• Giffen goods have a

  positive

  ---

  substitution effect and a

  negative

  ---

  income effect, but the positive substitution effect is less than the negative income effect.

Substitution and Income Effect with Indifference Curves

• Substitution Effect - when a product gets cheaper, you will naturally buy more of it because it is relatively cheaper compared to the other product. This is always represented by a movement along the same indifference curve.

• Income Effect - when a product gets cheaper, your purchasing power increases so it is like your income has increased. With this higher income, you can either buy more of the good or less depending on if it is normal or inferior. This is always represented by a shift to a different indifference curve.

• In the diagram above, as the budget line gets steeper it means the price of Y must have decreased
• The substitution effect is from point

  A

  ---

  to

  B

  ---

  because it's on the same indifference curve. This is a drop in quantity consumed of good X from 5 to 2 units.
• The income effect is from point

  B

  ---

  to

  C

  ---

  because we jump on to a different indifference curve. This is an increase in quantity of good X from 2 to 3 units.
• The total effect is from point

  A

  ---

  to

  C

  ---

• If the substitution effect is stronger than the income effect, then the two goods are

  substitutes

  ---

  . In the diagram above the two products must be substitutes.
• If the income effect is stronger than the substitution effect, then the two goods are

  complements

  ---

Normal and Inferior Goods

• If the income effect is positive the product is

  normal

  ---

  and if it is negative the product is

  inferior

  ---

• In the diagram above good X and Y are both normal because there is a positive income effect for both goods from point B to C.

Example: Substitution and Income Effect with Indifference Curves