The drop in price has both a substitution effect and an income effect. The substitution effect is the change in food consumption associated with a change in the price of food, with the level of utility held constant. The substitution effect captures the change in food consumption that occurs as a result of the price change that makes food relatively cheaper than clothing. This substitution is marked by a movement along an indifference curve. In Figure, the substitution effect can be obtained by drawing a budget line which is parallel to the new budget line RT (reflecting the lower relative price of food), but which is just tangent to the original indifference curve U1 (holding the level of satisfaction constant). The new, lower imaginary budget line reflects the fact that nominal income was reduced in order to accomplish our conceptual goal of isolating the substitution effect. Given that budget line, the consumer chooses market basket D and consumes OE units of food. The line segment F1E thus represents the substitution effect.
Figure makes it clear that when the price of food declines, the substitution effect always leads to an increase in the quantity of food demanded. The explanation lies in the fourth assumption about consumer preferences discussed innamely, that indifference curves are convex. Thus, with the convex indifference curves shown in the figure, the point that maximizes satisfaction on the new imaginary budget line parallel to RT must lie below and to the right of the original point of tangency.
Now let’s consider the income effect: the change in food consumption brought about by the increase in purchasing power, with relative prices held constant. In Figure, we can see the income effect by moving from the imaginary budget line that passes through point D to the parallel budget line, RT, which passes through B. The consumer chooses market basket B on indifference curve U2 (because the lower price of food has increased her level of utility). The increase in food consumption from OE to OF2 is the measure of the income effect, which is positive, because food is a normal good (consumers will buy more of it as their incomes increase). Because it reflects a movement from one indifference curve to another, the income effect measures the change in the consumer’s purchasing power
We have seen in Figure that the total effect of a change in price is given theoretically by the sum of the substitution effect and the income effect:
Total Effect(F1F2) = Substitution Effect(F1E) + Income Effect(EF2)
Recall that the direction of the substitution effect is always the same: A decline in price leads to an increase in consumption of the good. However, the income effect can move demand in either direction, depending on whether the good is normal or inferior.
A good is inferior when the income effect is negative: As income rises, consumption falls. Figure shows income and substitution effects for an inferior good. The negative income effect is measured by line segment EF2 . Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect. As a result, when the price of an inferior good falls, its consumption almost always increases.
A Special Case: The Giffen Good
Giffen good is a Good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect.
Theoretically, the income effect may be large enough to cause the demand curve for a good to slope upward. We call such a good a Giffen good, and Figure shows its income and substitution effects. Initially, the consumer is at A, consuming relatively little clothing and much food. Now the price of food declines. The decline in the price of food frees enough income so that the consumer desires to buy more clothing and fewer units of food, as illustrated by B. Revealed preference tells us that the consumer is better off at B rather than A even though less food is consumed.
Though intriguing, the Giffen good is rarely of practical interest because it requires a large negative income effect. But the income effect is usually small:
Individually, most goods account for only a small part of a consumer’s budget. Large income effects are often associated with normal rather than inferior goods (e.g., total spending on food or housing).