chapter 8: substitution and income effects

Substitution Effect

The change in demand for a good when its price decreases, making it relatively cheaper, keeping purchasing power constant.

Income Effect

The change in demand for a good when a price decrease makes consumers feel relatively wealthier, increasing their purchasing power.

Slutsky Identity

The total change in demand equals the substitution effect plus the income effect.

Calculating Substitution Effect

x1(p1’, m) - x1(p1, m).

Calculating Income Effect

x1(p1’, m) - x1(p1’, m’).

Slutsky Substitution Effect

A method that aims to afford the original consumption bundle at original prices.

Hicksian Substitution Effect

A method that adjusts income to achieve the same utility level as before a price change.

Normal Good

the substitution effect is negative and the income effect is also negative.

Slope of Demand Curve for Normal Good

The slope of the demand curve is negative.

Inferior Good

the substitution effect is negative, while the income effect is positive.

Slope of Demand Curve for Inferior Good

The slope of the demand curve is negative except for Giffen goods.

Giffen Good properties

the substitution effect is negative, the income effect is positive, and the slope of the demand curve is positive.

Reason for Positive Slope of Giffen Good

The income effect outweighs the substitution effect, which can only occur occasionally for inferior goods.

giffen good

an extremely inferior good with little to no substitutes.