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Economics/The income effect and the substiturion effect

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Question
Distinguish between the income and substitution of
a) normal good
b) a giffen good

Answer
Normal Good and Price Effect
Normal Good and Price  

Giffen Good and Price Effect
Giffen Good and Price  
Hi Livison,

Thank you for asking a question which is at once simple and intriguing –simple because these concepts form the bedrock of demand and utility analysis in any first course in microeconomics and, when explained at their barest rudiments, present outwardly no difficulty in comprehension; intriguing because, outwardly simple as these concepts are, they are apt to be analytically complex when viewed against a backdrop of intertwined strands of implications from connected variables and parameters.

To provide you with answer to your best satisfaction, let me first make a point clear. The question you have asked could be answered simplistically which you certainly would not want because it is assumed you have already had your preliminary homework prior to asking the question and taken the trouble to approach me for a deeper understanding. On the other hand, the question could be answered at a very advanced level, but that would only strike the chord of a professional mind, which I know is not the purpose of your query. My answer is based on the assumption –especially, when I don’t know of your academic background –that you have some grounding in economics, though not at any advanced level, but would like to have a thorough treatment of the topics under question that should be theoretically sound yet intelligible.
  
         THE FOUR PARTS OF THE QUESTION
Your question, so far I understand, relates to the “price effect” –which is a resultant of “income effect” and “substitution effect” –on two types of goods, normal good and Giffen good.  The question breaks down into:

1.   Income effect on a normal good
2.      Substitution effect on a normal good
3.   Income effect on a Giffen good
4.   Substitution effect on a Giffen good

Before I get down straight to answering your question, I believe it would be to your better comprehension if the following integral concepts are clearly spelled out. Here is thus a quick rundown.

         SOME IMPORTANT DEFINITIONS

(a)   PRICE EFFECT: Price effect is the impact that a change in the price of a product has on the quantity demanded of the good. Price Effect = Substitution Effect + Income Effect.

(b)   SUBSTITUTION EFFECT: Substitution effect is the impact that the change in the price of a product has on its relative expensiveness and consequently on the quantity demanded of the good.

(c)   INCOME EFFECT: Income effect is the impact that the change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of the good.

(d)   NORMAL GOOD: Normal goods are goods the demand for which varies directly with money income. When income rises, the demand for a normal good increases; when income falls, the demand for a normal good decreases.

(e)   INFERIOR GOOD: Inferior goods are goods the demand for which varies inversely with money income. When income rises, the demand for a normal good decreases; when income falls, the demand for a normal good increases.

(f)   GIFFEN GOOD: Giffen good is a special type of inferior good. Giffen good is a good the demand for which goes down when price of the good goes down. Giffen good violates the law of demand. Marshall cites the example from Giffen:... a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it. Since Giffen goods always have negative income effects, they must always be inferior goods. Thus, a Giffen good is always an inferior good, but an inferior good is not always a Giffen good.

(g)   VEBLEN GOOD: Veblen good –a special type of good which you haven’t asked about but which in causal relationship with price is akin to Giffen good –is good which has snob appeal, and the demand for the good goes up when price goes up, giving the consumer a feeling of superiority or prestige. American economist Veblen found it out from the behavior of the rich and British economist Giffen found out about Giffen good from the behavior of the poor.

         SUBSTITUTION EFFECT AND INCOME EFFECT ON A NORMAL GOOD [Attachment I]
I attach two very simple diagrams, one explaining substitution effect and income effect on normal good and another that on Giffen good. The distinct colored arrows should quickly indicate to you how these two effects may be viewed as a composite effect called price effect. Some understanding of “indifference curve” is presumed for diagrammatic understanding of the points. If you are not familiar with that, don’t worry; you still will be able to capture the idea. If you are familiar with that, or if you want to have a better understanding, please get hold of any elementary textbook on microeconomics.

[By the way, if you have an elementary mathematical background, it would pay you to look up this point: marginal utility of good X divided by price of X equals marginal utility of good Y divided by price of Y. If you care for intermediate level math, you may enjoy this treatment with optimization of utility using total differential and Lagrange multiplier. I don’t know about your math background, but I assure you a student with almost no mathematical background is not going to lose anything in my explanation which I have tried to make the least mathematical.]

•   Assume consumer’s budget constraint –he has only that much money, M, which he spends on two goods, X and Y. [If you are not shy of school-level algebra, take it as M=pX+PY, where p=price of X and P=price of Y.]

•   Please refer to Attachment I. Suppose we have two goods, X and Y, shown geometrically along horizontal axis (X) and up the vertical axis (Y). Suppose price of X is shown in terms of Y and price of Y in terms of X. That is, vertical intercept of the budget line shows price of X and horizontal intercept of the budget line shows price of Y. [You may take the vertical intercept as the maximum amount of Y the consumer buys when buys no X –that intercept, given the budget equation M=pX+PY,  equals M/Y. Similarly the horizontal intercept is M/X.] The slope (relative slant of the downsloping budget line—the black curve from northwest to southeast) shows the relative prices of X and Y, given an income M. Of course, as you know, if the price of a good falls, you can afford more of the good. Naturally, therefore, if the price of X falls, the price of Y remaining constant, then at unchanged price of Y and lower price of X, the same amount of Y and a larger amount of X can be bought.

•   As price of X falls, and as consumer can buy more of X, his budget line rotates rightward, and we have the RED budget line. [You may find that M/X, the red-budget-line intercept, is larger.] This red budget line is now tangent to indifference curve 2, which as you know shows higher level of satisfaction than does indifference curve 1. Because of the fall in price of X, the consumer can now have more of X, as shown by the RED ARROW.

•   Let’s take resort to an analytical trick. Suppose his extra income is taken away so as to make him have the same (original) real income level. Now having the previous income level but confronted with the new set of prices for X and Y, “[same price of Y, lower price of X],” the consumer has a new [lower-income] budget line with the slope as that of the red line. This new budget line is shown by the BLUE budget line. The BLUE ARROW shows the substitution effect on X [increase in X] due to a change in price of X [fall in price of X relative to price of Y].

•   Get back to the RED BUDGET LINE. This red budget line, parallel to the blue budget line, shows consumer’s increase in INCOME. You know, Livison, that rightward parallel shift of the budget line which indicates higher affordability on the part of the consumer exhibits an INCREASE IN INCOME. The shift from blue to red shows the REAL INCOME change. This also causes a change in X, as shown by the BLACK ARROW.

•   The blue, black and red arrows show that there is a two-pronged effect on the quantity demanded of X. The sum is the price effect.

         SUBSTITUTION EFFECT AND INCOME EFFECT ON A GIFFEN GOOD [Attachment II]
•   Suppose we have two good, X and Y, shown geometrically along horizontal axis (X) and up the vertical axis (Y). As in the case of Normal Good, also suppose price of X is shown in terms of Y and price of Y in terms of X.

•   The black curve from northwest to southeast shows the relative prices of X and Y, given an income M. Of course, as you know, if the price of a good falls, you can afford more of the good. Naturally, therefore, if the price of X falls, the price of Y remains constant, then at unchanged price of Y and lower price of X, the same amount of Y and a larger amount of X can be bought. This is shown by the BLUE ARROW when we have taken away income from the consumer to leave him at the original level of his income before the fall in price of X. The blue arrow shows the consumer is in this position able to substitute X for Y. This would have been his tendency.

•   This tendency to substitute X for Y is much too far outweighed by the desire to buy more of a normal good now that his income has gone up.

•   Take it this way.  The American consumer in this hypothetical situation may be buying junk food. The price of junk food falls. As a result, the American consumer’s monthly outlay on junk food falls by a sizable amount. This extra amount which he had to spend before the fall in junk food price is fortuitously saved by him since this he doesn’t have to spend on X now that price of X has fallen. His real income due this saving has gone up.

•   With a fatter wallet, the American consumer now aspires to have better quality food –say; he now goes for organic foods. Since now he goes for better-quality food, he has less need for junk foods. Therefore, his demand for junk food falls, and that works in violation of the law of demand: the price of junk food has fallen and the quantity demanded of junk food has gone down, and there is an upsloping demand curve.  Junk food is a Giffen good in this example of ours, and the price effect is shown by the westward red arrow. Price falls, demand goes down. Giffen in fact gave examples of butter and margarine –during those days in relatively poor Britain [compared to today’s rich America] that was an apt illustration. By the bye, Veblen good also violates the law of demand.

I hope, Livison, I have been able to give a full-dress explanation of what you wanted in your question.
Best of luck.  

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Eklimur Raza

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It appears some students in this website are confused about elasticity of demand and the slope of the demand curve when they are trying to figure out why rectangular hyperbola comes up in case of unitary demand curve. First, they don't know that RH can be depicted in a positive quadrant of price,quantity plane. Secondly, they make the mistake that the slope of RH is constant at -1. Two points could help them: first, e=1 at each and every point of the RH, because the tangent at any point shows lower segment=upper segment (another geometric definition of e); yet slopes at different points,dQ/dP, are different; second, e is not slope but [(Slope)(P/Q)]in absolute terms. Caveat: only if we measure (log P) along the horizontal axis and (log Q) up the vertical axis, can we then say slope equals elasticity --in which case RH on P,Q plane is transformed into a straight-line demand curve [with slope= -tan 45 deg] on (log Q),(logP) plane, and e= -d(log Q)/d(log P). [By the way, logs are not used in college textbooks --although that is helpful in econometric estimation of elasticity viewed as an exponent of P, when demand equation is transformed into log-linear form.] I have not found the geometrical explanation I have given in any textbook followed in undergraduate and college classes in Canada (including the book followed in a university where I taught for a short time and in the book followed in George Brown College, Toronto, where I teach.

Experience

About 11 years' teaching economics and business studies, and also English, history and elementary French.Practical experience in a development bank, working with international donor agencies like the World Bank and the ADB. Experience in free-lance journalism, including Canada's "National Post."

Organizations
I teach micro- and macroeconomics at George Brown College (continuing education), Toronto, ON, Canada.

Publications
Many articles and editorials, on different subjects, in English newspapers. Recently an applied Major Research Paper, based on a synthesis of the Solow growth model and the Lewis two-sector model, has be accepted by Ryerson University, Toronto. Professors Thomas Barbiero and Eric Cam, Ryerson University, accepted the paper.

Education/Credentials
Master degree in Interantional Economics and Finance and diploma with honours in Business Administration from Canada.

Awards and Honors
Received First Prize in an inter-university Literary Contest.

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