Welcome back to my blog! In today’s blog, I will introduce you the relationship between income &substitutional effect and the demand of products.

Generally speaking, Substitution effect moves quantity demanded in the opposite direction to the price change: when price decreases (increases), substitution effect works to increase (decrease) quantity demanded; Income effect can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior.

It is possible to illustrate the substitution and income effects of the fall in the price of a good diagrammatically.  We begin by identifying the substitution effect. In order to do this we need to remove the income effect which is achieved by drawing in a new budget line, SV, parallel to the new budget line (RT), but tangential to the original indifference curve (I1). This leaves the individual on the original indifference curve and shows how much of good B would have been purchased had their real income not been increased. The movement from X to Z represents the substitution effect. The rest of the movement from X to Y is, therefore, the income effect.

It can be seen that when the price of good B is reduced the change in the quantity demanded resulting from the substitution effect is the movement from B1 to B3 and that resulting from the income effect by the movement from B3 to B2. In the case of a normal good ,the income and substitution effects of the price fall have worked in the same direction in order to bring about an increase in the quantity of B demanded.

This graph illustrates the situation for an inferior good.

An inferior good is one for which the quantity demand will fall as consumers’ income rises. In this case the substitution and income effects move in opposite directions. The substitution effect increases the demand from B1 to B3, but the negative income effect moderates the increase to some extent and will reduce the consumption of B from B3 to B2.

The final graph illustrated a Giffen good.

Giffen goods are generally regarded as goods of low quality which are important elements in the expenditure of those on low incomes. A good example is a basic food such as rice, which forms a significant part of the diet of the poor in many countries. The argument, not accepted by all economists, is that when the price of rice falls sufficiently individuals’ real income will rise to an extent that they will be able to afford more attractive substitutes such as fresh fruit or vegetables to make up their diet and as a result they will actually purchase less rice even though its price has fallen. In this case, the negative income effect (B3 to B2) completely outweighs the substitution effect (B1 to B3).

That’s all for today’s blog! For the next time, we will talk about different market structures.