Income & Substitution Effects

Normal & Inferior Goods

substitution effect (SE)

change in consumption of a good due to a change in its relative price, moving along the same indifference curve

income effect (IE)

change in consumption of a good due to the change in real income (purchase power) caused by a price change

total effect

substitution effect + income effect: from original bundle to new bundle after price change

hypothetical budget line

a line parallel to the new budget line, tangent to the original indifference curve - used to isolate SE from IE

normal good

demand increases when income increases (positive income elasticity). SE and IE work in the same direction

inferior good

demand increases when income decreases (negative income elasticity). SE and IE work in opposite directions

giffen good

a special type of inferior good where the income effect is so strong that it outweighs the substitution effect, causing demand to rise when price rises (very rare)

engel curve

a graph showing the relationship between income and quantity demanded of a good