QUESITON 1:

INCOME AND SUBSTITUTION EFFECT

In general, a change in the price of a good has two effects –a substitution effect and an income
effect. The substitution effect is associated with a change in the consumption of one commodity
in relation to a change in the price of another or the same commodity, at a constant utility. The
income effect on the other hand is associated with a change in the consumption of a commodity
due to a change in the real income resulting from a price change.

The above phenomena can be captured in what is called the SLUTSKY equation. The Slutsky
equation represents the total change in consumption of a commodity that results from a change in
the price of the same commodity. As a result, the change in commodity X resulting from a
change in its price is denoted as;

∂x ∂x ∂x
= − − x
∂px ∂p x u ∂I

The first term on the right-hand-side represents the substitution effect and the second term
represents the income effect.

Alternatively, we can decompose this total effect resulting from a price change by way of a
diagrammatic approach. It is worthy to note that the two effects occur simultaneously, that is,
they do not occur in isolation. However, the total effect depends on the magnitude of each effect.
We depict this as follows;

Suppose a consumer enjoys two commodities X and Y, as shown in Figure 1.We suppose
initially that this consumer is maximizing his utility at point A, where he consumes X0 of X and
Y0 of Y. This is the point where his indifference curve (IC0) becomes tangential to his budget
line M0N0.

To progress in our analysis, we assume that the price of commodity X now falls so that X
becomes cheaper relative to Y. Now, the resulting effect will depend on three main issues –
whether X is

1. A normal good,
2. An inferior good ( not giffen)
3. An inferior good (giffen)

We now consider the first case.

If commodity X is a normal good the fall in price will render commodity X cheaper or more
attractive to the consumer relative to Y. As a result, the budget line rotates outward to M0N1
because his real income now increases. We see that to maximize utility, the consumer will move
onto a higher indifference curve IC1 which is tangential to the budget line at point B. The
consumer now substitutes some quantities of Y for X, so that the new equilibrium combination is
X1Y1. Here, the total effect will be X1-X0. However, we can decompose this total effect into the
substitution effect and the income effect. As the price of commodity X falls the consumer
becomes richer resulting in an outward rotation of the budget line, pivoted at M0. Now, to let this
consumer stay on the initial indifference curve, we confiscate a portion of his nominal income
just enough, preferably, (the excess over his initial income) to achieve this purpose. We realize
that in doing this, the budget line falls back to M1N2 which is parallel to M0N1 and is tangential to
IC1 at point C. At this point, the consumer is unable to consume X1 anymore. There needs to be a
trade-off. Still with commodity X appearing cheaper, he will now consume X2 amounts of X, by
substituting some quantities of Y (Y2 – Y1) to make this possible. The distance X0 – X2 now
becomes our substitution effect (since it occurs along the same indifference curve) and the
movement from X2-X1 represents our income effect.

M0
M1

Y0
Y2
IC0 IC1
Y1

X0 X2 X1 N0 N1 N2 X

FIGURE 1: INCOME AND SUBSTITUTION EFFECT

FOR A NORMAL GOOD, RESULLTING FROM A
CHANGE IN THE PRICE OF X1.

It is worthy to note that with a normal good the negative substitution effect less than offsets the
negative income effect, so that the total effect becomes negative. So, in relation to the Slutsky
equation, (substitution effect) is always negative because of the trade-off with a price
∂x
−
∂Px u
change, and (income effect) is negative for a normal good. So, > . Hence, the
∂x ∂x ∂x
−x
∂I −
∂Px u ∂I

total effect is , which is negative.

∂x ∂x ∂x
= − − x
∂px ∂px u ∂I

We now consider the case of an inferior good X which is not giffen. As the price of commodity
X falls, the real income of the consumer increases. From figure 2, with the initial utility
maximization bundle being X0Y0 at point A, X becomes less attractive, because the real income
of the consumer now increases and would therefore want to consume more of a normal good, so
less of X will be consumed. By this, the new consumption bundle will now be on a higher
indifference curve (IC2) on the budget line M0N1 at the point B, where he now consumes X1 of X
and Y1 of Y. Now, in order to let this consumer stay on the initial indifference curve, we
confiscate as much nominal income from him so that his new consumption bundle becomes X2Y2
on the new budget line M1N2 at point C. But, as we do this the quantities of X increase more than
the initial, however, this will be short-lived. The income effect resulting from this change in real
income now becomes X1 – X2 which is positive, so that it reinforces the negative substitution
effect. Hence, the total effect is now X1 – X0 which is negative. Here, the positive income effect
is not large enough to outweigh the negative substitution effect, so the total effect is negative.
That is, > , so is negative. This is depicted as below;
∂x ∂x ∂x ∂x ∂x
x = − − x
−
∂Px u ∂I ∂px ∂px u ∂I

M0
M1

Y1
Y0

Y2
FIGURE 2: INCOME AND SUBSTITUTION EFFECT ON A N
INFERIOR GOOD WHICH IS NOT GIFFEN, RESULTING FRO A
CHANGE IN THE PRICE OF X1.
X0 X1 X2 N0 N2 N1 X
Now, let us consider the case of a giffen good. We assume that initially the consumer is
consuming X0 of X and Y0 of Y at point A where the indifference curve is tangential to the
budget line. With a fall in price, the real income of the consumer increases. But, with X being
inferior, he will prefer consuming more of Y to X. We now decompose this effect into
substitution effect and income effect. Now, as price of X falls, the budget line now becomes
M0N1 which is tangential to IC1 at point B where the consumer now consumes X1Y1 commodity
bundles. To let the consumer stay on the same indifference curve, we confiscate a portion of his
nominal income, enough to achieve this purpose. As this is done, he now substitutes some
quantities of X for Y, thus consuming X2Y2. The substitution effect of a price change now
becomes X2 – X0 and the income effect becomes X2 – X1. As it is realized from figure 3, the
positive income effect more than offsets the negative substitution effect. Thus, the total effect
now becomes X0 – X1, which is positive. Thus, for a giffen good, the positive income effect more
than offsets or outweighs the negative substitution effect, whereas, for an inferior good the
positive income effect does not outweigh the negative substitution effect. Thus, all giffen goods
are inferior but not all inferior goods are giffen goods. In relation to the Slutsky equation, we
have that (substitution effect) is negative and is positive, but > .
∂x ∂x ∂x ∂x
x x
−
∂Px u ∂I ∂I −
∂Px u

Hence, the total effect is positive. Therefore, is positive.

∂x ∂x ∂x
= − − x
∂px ∂px u ∂I

M0

M1
Y2
1 IC
FIGURE 3: INCOME AND SUBSTITUTION EFFECT ON A GIFFEN
X
X0 IC0
GOOD,
YO RESULTING FROM A CHANGE IN THE PRICE OF X1.
Y1

X2 X1 N2 NO N1