Interrelationship among Inferior Goods, Giffen Goods and Law of Demand
Indifference curve analysis with its technique of looking upon the price effect as a combination of income effect and substitution effect explains relationship. An inferior good will see less consumption as income rises while a normal good will see a positive relationship between more income and quantity demanded. Inferior good is a good whose demand increases when the consumer's income decreases and whose demand decreases as the consumer's income increases.
The substitution effect which is always negative and operates so as to raise the quantity demanded of the good if its price falls and reduces the quantity demanded of the good if its price rises.
Thus, in case of normal goods both the income effect when positive and negative substitution effect work in the same direction and cause increase in the quantity purchased of good X whose price has fallen with the result that the new equilibrium point will lie to the right of the original equilibrium point Q such as point R in Fig. Substitution effect causes MK increase in quantity demanded.
Income effect which is positive here also leads to the increase in quantity demand by KN. Each effect therefore reinforces the other. To sum up, the income effect and substitution effect in case of normal goods work in the same direction and will lead to the increase in quantity demanded of the good whose price has fallen.
In other words, quantity purchased of a normal good will vary inversely with its price as in its case income effect is positive. In case of inferior goods the income effect will work in opposite direction to the substitution effect.
When price of an inferior good falls, its negative income effect will tend to reduce the quantity purchased, while the substitution effect will tend to increase the quantity purchased. But normally it happens that negative income effect of change in price is not large enough to outweigh the substitution effect. This is so because a consumer spends a very small proportion of his income on a single commodity and when price of a commodity falls, a very little income is released.
In other words, income effect even when negative is generally too weak to outweigh the substitution effect. It follows therefore that as a result of fall in price of a good the. Thus even in most cases of inferior goods the net result of the fall in price will be increase in its quantity demanded.
It is thus clear that in a majority of inferior goods quantities demanded of the good will vary inversely with price and the Marshallian law of demand will hold good.
The price-demand relationship in case of inferior goods having weaker income effect is illustrated in Figure 8. It will be seen from Fig. But the income effect is negative and is equal to HT. If income effect alone was working, it would have caused the consumer to buy HT less of good X. But substitution effect is universally present and always induces the consumer to buy more of the relatively cheaper good. Therefore, the net effect of the fall in price of good X is the increase in quantity demanded by MT.
Hence we conclude that in case of inferior goods, quantity demanded varies inversely with price when negative income effect is weaker than the substitution effect. In other words, even in case of inferior goods having weaker income effect, the demand curve will be downward sloping.
Giffen Goods or Giffen Paradox: There is a third possibility. This is that there may be some inferior goods for which the negative income effect is strong or large enough to outweigh the substitution effect. In this case, quantity purchased of the good will fall as its price falls and quantity purchased of the good will rise as its price rises. In other words, in this case quantity purchased or demanded will vary directly with price.
Now, the income effect can be substantial only when the consumer is spending a very large proportion of his income on the good in question so that when price of the good falls, a good amount of income is released. If that good happens to be inferior good, the income effect will be negative as well as strong and may outweigh the substitution effect so that with the fall in price, the consumer will buy less of the good.
Such an inferior good in which case the consumer reduces its consumption when its price falls and increases its consumption when its price rises is called a Giffen good named after the British statistician, Sir Robert Giffen, who in the mid- nineteenth century is said to have claimed that when price of cheap common foodstuff like bread went up the people bought and consumed more bread.
A rise in the price of bread caused such a large decline in the purchasing power of the poor people that they were forced to cut down the consumption of meat and other more expensive food. Since bread even when its price was higher than before was still the cheapest food article, people consumed more of it and not less when its price went up.
Similarly, when price of an inferior good, on which people spend a large proportion of their income, falls people will purchase less than before.
This is because the fall in price of an inferior good on which they spend a very large portion of their income causes such a large increase in their purchasing power that creates a large negative income effect. They will therefore reduce the consumption of that good when its price falls since large negative income effect outweighs the substitution effect.
The price-demand relationship in case of a Giffen good is illustrated in Fig. With a certain given price-income situation depicted by the budget line PL1, the consumer is initially in equilibrium at Q on indifference curve IC1.
With a fall in price of the good, the consumer shifts to point R on indifference curve IC2.Giffen Good Example - Price Change, Income and Substitution Effect - Intro to Microeconomics
It will be seen From Fig. This is the net effect of the negative income effect which is here equal to HN which induces the consumer to buy less of good X and the substitution effect which is equal MH which induces the consumer to buy more of the good. Since the negative income effect HN is greater than the substitution effect MH, the net effect is the fall in quantity purchased of good X by MN with the fall in its price.
Thus, the quantity demanded of a Giffen good varies directly with price. Therefore, if a demand curve showing price-demand relationship of a Giffen good is drawn, it will slope upward. Thus the relation between price and quantity demanded being inverse, the substitution effect of a price change is always negative, real income being held constant.
The Substitution and Income Affects from the Price Effect (Inferior and Giffen Goods)
This is known as the Slut-sky Theorem, named after Slut-sky who first stated it in relation to the Law of Demand. To isolate the income effect from the price effect, return the income which was taken away from the consumer so that he goes back to the budget line PQ1 and is again in equilibrium at point T on the curve I2.
The movement from point H on the lower indifference curve I1 to point T on the high indifference curve I2 is the income effect of the fall in the price of good X. By the method of compensating variation in income, the real income of the consumer has increased as a result of the fall in the price of X.
The consumer purchases more of this cheaper good X thus moving on the horizontal axis from D to E. This is the income effect of the fall in the price of a normal good X The income effect with respect to the price change for a normal good is negative. In the above case, the fall in the price of good X has increased the quantity demanded by DE via the increase in the real income of the consumer.
Thus the negative income effect DE of the fall in the price of good X strengthens the negative substitution effect BD for the normal good so that the total price effect BE is also negative, that is, a fall in the price of good X has led, on both counts, to the increase in its quantity demanded by BE.
Giffen goods in economics, examples with graphs - avb4you.info, Learning Economics Solved!
This can be written in the form of the Slut-sky equation thus: Substitution and Income Effects for an Inferior Good: If X is an inferior good, the income effect of a fall in the price of X will be positive because as the real income of the consumer increases, less quantity of X will be demanded. This is so because price and quantity demanded move in the same direction On the other hand, the negative substitution effect will increase the quantity demanded of X.
The negative substitution effect is stronger than the positive income effect in the case of inferior goods so that the total price effect is negative. It means that when the price of the inferior good falls, the consumer purchases more of it due to compensating variation in income.
The case of X as an inferior good is illustrated Figure Initially, the consumer is in equilibrium at point R where the budget line PQ is tangent to the curve I1. By compensating variation in income, he is in equilibrium at point H on the new budget line MN along the original curve I1.
To isolate the income effect, return the increased real income to the consumer which was taken from him so that he is again at point T of the tangency of PQ; line and the curve l2. This income effect is positive because the fall in the price of the inferior good X leads, via compensating variation in income, to the decrease in its quantity demanded by DE.
When the relation between price and quantity demanded is direct via compensating variation in income, the income effect is always positive.
In the case of an inferior good, the negative substitution effect is greater than the positive income effect so that the total price effect is negative.
In other words, the overall price move from R to T which comprises both the income and substitution effects has led to the increase in the quantity demanded by BE after the fall in the price of X. This establishes the downward sloping demand curve even in the case of an inferior good. Substitution and Income Effects for a Giffen Good: A strongly inferior good is a Giffen good, after Sir Robert Giffen who found that potatoes were an indispensable food item for the poor peasants of Ireland.
He observed that in the famine ofa rise in the price of potatoes led to an increase in their quantity demanded. Thereafter, a fall in the price led to a reduction in their quantity demanded.