Substitution and income effects of the price effect (inferior goods and Giffen) (2023)

The substitution and income effects of the price effect (inferior goods and Giffen goods)!

We have seen that a fall in the price of good X, given the price of good Y, increases its demand. This is the price effect, which works in two ways: a substitution effect and an income effect. The substitution effect refers to the increase in the quantity demanded of X as its price decreases while the consumer's real income remains constant.

The consumer substitutes the cheaper good X for the relatively more expensive good Y. The income effect is the increase in the quantity demanded of X when the consumer's real income increases as a result of a fall in the price of X while the price of Y falls. . There are two methods to separate these two effects from the price effect, the Hicksian method and the Slut Sky method, which are explained below.

Hicks separated the substitution effect and the income effect from the price effect by compensating for fluctuations in income by changing the relative price of a good while the consumer's real income remains constant.

Assume that the consumer is initially in equilibrium at point R on the budget line PQ, where the indifference curve I₁is tangent to it at point R in Figure 12.19. Lower the price of Good X. As a result, your budget line pivots out to PQ₁where the consumer is in equilibrium at point T on the greatest indifference curve I₂🇧🇷 The movement from R to T or B to E on the horizontal axis is the price effect of the falling price of X. As the price of X decreases, the consumer's real income increases. To make the compensatory change in income to isolate the substitution effect, the consumer's money income is reduced by the equivalent of PM of Y or Q₁N of X drawing the MN budget line parallel to PQ₁so that it is tangent to the originalindifferenceCurveeu₁noH-spot

The movement from R to H on curve 11 is the substitution effect, where the consumer increases his purchases of X from В to D on the horizontal axis, substituting X for К because it is cheaper. Note that when the price of good X falls (or rises), the substitution effect always leads to an increase (or decrease) in its quantity demanded. Thus, as the relationship between price and quantity demanded is inverse, the substitution effect of a price change is always negative, while real income is kept constant. This is known as Slut-sky's theorem, named after Slut-sky, who first formulated it in terms of the law of demand.

To isolate the income effect from the price effect, return the income that was taken from the consumer back to the budget line PQ₁and is again in equilibrium at point T on curve I₂🇧🇷 The movement of point H on the lower indifference curve I₁to point T on the high indifference curve I₂is the income effect of the fall in the price of good X. By the income compensation method, the consumer's real income has increased as a result of the fall in the price of X. The consumer buys cheaper So good X moves on the horizontal axis of D for E. This is the income effect of the fall in the price of a normal good X. The income effect related to the change in the price of a normal good is negative.

In the case above, the fall in the price of good X increased the quantity demanded for DE via an increase in the consumer's real income. Thus, the negative income effect DE of the fall in the price of good X amplifies the negative substitution effect BD of the normal good, so that the total price effect BE is also negative, that is, it led to a fall in the price of good X, in both cases to an increase in the quantity demanded by BE. This can be written in terms of the Slut-Sky equation as follows:

Price effect (-) BE-(-) BD (substitution effect + (-) DE (income effect).

Substitution and income effects for an inferior good:

If X is an inferior good, the income effect of a fall in the price of X is positive, since less X is demanded as the consumer's real income rises. This is because price and quantity demanded move in the same direction. On the other hand, the negative substitution effect increases the quantity of X demanded.

For inferior goods, the negative substitution effect is stronger than the positive income effect, so the overall price effect is negative. This means that if the price of the inferior good falls, the consumer will buy more of it because he is smoothing out fluctuations in income. The case of X as an inferior good is shown in Figure 15.20. Initially, the consumer is in equilibrium at point R, where the budget line PQ touches the I curve._1.As the price of X declines, it moves to point T on the budget line PQ₁, on the highest indifference curve Its movement from R to Tor from В to E on the horizontal axis is the effect of price. By compensating for fluctuations in income, he is in equilibrium at point H on the new budget line MN along the original curve I₁.

The moves from R to H in I₁Curve is the substitution effects measured horizontally by BD of X. To isolate the income effect, return to the consumer the increase in real income that was withdrawn from him, so that he is again at the point T of the tangent of PQ_;line and the l-curve₂🇧🇷 The movement from H to T is the income effect of the falling 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 to a reduction in the quantity demanded for DE through compensating fluctuations in income. When the relationship between price and quantity demanded is direct via compensation for fluctuations in income, the income effect is always positive.

For an inferior good, the negative substitution effect is greater than the positive income effect, so the overall price effect is negative. Thus, the price effect is (-) BE = (-) BD (substitution effect) + DE (income effect). In other words, the total price movement from R to T, which includes income and substitution effects, led to an increase in the quantity demanded for BE after the price of X fell. This explains the downward sloping demand curve, even in the case of an inferior good.

Substitution and income effects for a Giffen good:

A highly inferior good is a Giffen good, named after Sir Robert Giffen, who observed that potatoes were an essential food for poor farmers in Ireland. He noted that in the famine of 1848, a rise in the price of potatoes led to an increase in quantity demanded. Thereafter, a fall in price led to a reduction in quantity demanded.

This direct relationship between price and quantity demanded for essential foods is known as Giffen's paradox. The reason for such a paradoxical trend is that the increase in the price of some foods, such as pasta bread, is equivalent to a decrease in the consumer's real income, which reduces their spending on more expensive foods, consequently, as the demand for bread increases. increases. Likewise, a fall in the price of bread increases the real income of consumers who substitute bread for expensive groceries, thus reducing the demand for bread.

For a Giffen good, the positive income effect is stronger than the negative substitution effect, so the consumer buys less when its price falls. This is shown in Figure 12.21. Suppose X is a Giffen good and the initial equilibrium point is R, where the budget line PQ is tangent to the indifference curve l₁🇧🇷 Now the price of X falls and the consumer moves to point T on the tangent between the budget line PQ_:and the curve I₂🇧🇷 Its movement from point R to T is the price effect, reducing its consumption of X per BE.

To isolate the substitution effect, the consumer is deprived of the increase in real income caused by the fall in the price of X by drawing the budget line MN parallel to PQ₁and is tangent to the original curve I₁at point H. As a result, it moves from point R to H along the l₁Curve. This is the negative substitution effect, causing him to buy more than X BD as its price falls, with real income remaining constant. To isolate the income effect, when the withdrawn income is returned to the consumer, the consumer moves from point H to T, thus reducing the consumption of X by a very large amount of DE. This is the positive income effect, because as the price of Giffen X's good falls, his quantity demanded for DE decreases by compensating for fluctuations in income. In other words, it is positive with respect to price change, i. H. the decrease in the price of good X leads to a decrease in the quantity demanded through the income effect.

Thus, for a Giffen good, the positive income effect is stronger than the negative substitution effect, so the overall price effect is positive. Because of this, the demand curve for a Giffen good has a positive left-to-right slope. Thus, the price effect is 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 a strong income effect; and (iii) the substitution effect must be weak. But Giffen products are very rare and can meet these conditions.