- Substitution effect
- The substitution effect is the change in the quantity bought because a price change makes one good relatively cheaper and another relatively dearer.
- Income effect
- The income effect is the change in the quantity bought because a price change alters the buying power of a given income.
The pieces of the split
Can you name the four ideas you need to split a price change in two?
At A-level a demand curve slopes down because a cheaper good is bought instead of others and leaves buyers better off. These four ideas pull those two reasons apart on an indifference curve diagram.
A compensated budget line is drawn parallel to the new budget line but tangent to the original indifference curve, so relative prices change and utility does not.
Can you think of an example?
The price of X falls and the budget line pivots out. Slide the new line back in, keeping its slope, until it just touches the old curve. What it slides back is the gain in buying power; the rest is pure substitution.
A normal good is one where a rise in income leads to a rise in the quantity consumed, and a fall in income to a fall.
Can you think of an example?
Cinema tickets get cheaper. They are now cheaper than other nights out, so you swap towards them, and the money saved buys more of everything, tickets included. Both effects push the same way.
An inferior good is one whose quantity consumed falls as income rises, because people can now afford the more expensive choices they prefer.
Can you think of an example?
Own-brand beans get cheaper, so you swap towards them. But the saving leaves you better off, and some of it goes back on the branded tin, so the income effect pulls the quantity of own-brand beans down.
A Giffen good is an inferior good whose income effect is larger than its substitution effect, so a rise in its price raises the quantity demanded.
Can you think of an example?
Robert Jensen and Nolan Miller gave poor households in Hunan, China, vouchers that cut the price of rice. Some bought less rice and more meat: rice took so much of their budget that the saving let them trade up.