From ZuluNotes - Free Leaving Cert Notes
Following a price fall, there are two effects on the consumer, the Substitution Effect and the Income effect. Together they are referred to as the price effect
Normal goods obey the law of demand. They also have a positive income effect. This means that as a income rises, demand rises, because the consumer can afford to buy more.
Inferior Goods also obey the law of demand, but they have a negative income effect. I.e. as Income rises, demand falls. This is usually because when a customer has more money they have increased choice and they can afford to buy better quality goods, or vary their consumption. An example of an inferior good would be a staple food such as rice. A poor family might buy only rice, and as the price of rice falls, they would buy more (obeying the law of demand). If the income level of the family rises, they can afford to buy different more expensive foods and vary their diet, and therefore the demand for rice falls.
Giffen goods are inferior goods, that break the law of demand.
Real income is the purchasing power of the consumer's money income. If income rises by 10% but at the same time prices rise by 10%, the real income remains unchanged.
The substitution effect refers to the fact that consumers will buy more of the relatively cheaper good. For example, if price falls, the good becomes cheaper compared to substitute goods, and demand increases. The substitution effect is positive for all goods.
The income effect is the change in a consumer's real income after a price change. I.e. If the price drops, your real income (the purchasing power of your money) will increase. For example, if John earns €10 per day, and spends it all on one €10 meal. If the price of that meal falls to €5, he can now buy two meals, or a meal and something else, and therefore, even though his wage hasn't changed, his real income (purchasing power) has doubled.
|Type of Good||Subst. Effect||Income Effect||Price Effect|
|Normal||Positive||Positive||Positive - obeys the law of demand|
|Inferior||Positive||Negative (small)*||Positive - obeys the law of demand|
|Giffen||Positive||Negative (large)||Negative - breaks the law of demand|
- For the inferior good, the positive substitution effect is stronger than the negative income effect, and therefore the overall price effect is positive. A negative income effect occurs when a consumer's increase of real income is more important than the fact that the good has become cheaper. For example: If I earn €10 per day, and a bag of rice costs €5 and a small steak costs €7, I buy two bags of rice, because a small steak wouldn't be enough food. If the price of a bag of rice falls to €3, I might then buy a steak and a bag of rice each day. In this case, the increase in my purchasing power (real income) that I got from a price drop in rice has actually made me purchase less rice. This is what happens in the case of a giffen good. Getting bored of eating rice every day and wanting some steak is explained by the Law of Equi-Marginal Returns.