Answer to Question #190081 in Microeconomics for Ridham Mittal

Question

Explain diagramatically and theoretically the working of price effect, income effect and substitution effect- difference between inferior goods and Giffen goods.

Answer 1

The income effect -

The income effect considers the change in real income or purchasing power due to the change in price level of any good.

The substitution effect -

The substitution effect considers the change in relative price due to the change in price level of any good. It explains the change in the consumption of that good.

The price effect -

The summation of income effect and substitution effect results in the net change in the consumption, which reflects the price effect.

 

Inferior goods are relatively poor quality goods, which have a negative relationship between their demand and income level.

Giffen goods are highly inferior goods which have a positive relationship between the demand for giffen goods and price level.

Inferior goods

The income effect works in the opposite direction to the substitution effect. When the price falls, it's negative effect tends to reduce the purchased quantity whereas substitution effect tends to increase the purchased quantity. Normally, the negative income effect of price change is so small to outweigh the substitution effect because, consumers spend little portion of their income on a single commodity so when price falls, little income is released.

Due to price fall, substitution effect induces the consumer to purchase more of the commodity whose price has decreased hence outweighs the negative income effect.

Giffen goods

Price income-situation is depicted by budget line PL1. Initially, the consumer is is at equilibrium Q on the indifference curve IC1. Price fall shifts the consumer to point R on indifference curve IC2, hence shift of the budget line from PL1 to PL2. Therefore, the consumer reduces consumption of commodity X from OM to ON.

This is termed as net effect of the negative income effect and equals to HN and induces the consumer to purchase less of commodity X. Net negative income effect HN is greater than substitution effect HM hence the net effect is the fall in purchased quantity of commodity X by MN following it's fall in price.