Income Effect and Substitution Effect, their differences, diagram explanation, and whether paradoxical results arise from one or both:
25/June/2025 01:04
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Here's a brief but detailed explanation of Income Effect and Substitution Effect, their differences, diagram explanation, and whether paradoxical results arise from one or both:
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? 1. Income Effect – Explained Briefly
The income effect refers to the change in quantity demanded of a good due to a change in real income or purchasing power caused by a change in the good’s price.
When price falls, real income increases → consumers feel richer → may buy more (positive income effect).
When price rises, real income decreases → consumers feel poorer → may buy less.
> It reflects how change in price affects demand through the consumer’s effective income.
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? 2. Substitution Effect – Explained Briefly
The substitution effect refers to the change in quantity demanded due to a change in relative prices, prompting consumers to substitute cheaper goods for more expensive ones.
When price of a good falls, it becomes relatively cheaper than its substitutes → demand for it increases.
When price rises, consumers switch to other substitutes → demand for the original good falls.
> It reflects how consumers reallocate consumption to maintain satisfaction as relative prices change.
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? 3. Difference Between Income and Substitution Effect
Basis Income Effect Substitution Effect
Definition Change in demand due to change in real income Change in demand due to change in relative prices
Direction Can be positive or negative Always positive for price fall
Impact on Normal Goods Increases demand when price falls Increases demand when price falls
Impact on Inferior Goods May reduce demand if income effect is negative Still increases demand when price falls
Example Buying more of luxury as you feel richer Switching to cheaper brand of tea from coffee
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? 4. Separation of Income and Substitution Effect: Hicksian Method (with Indifference Curve)
Using Indifference Curve Analysis:
1. Original Equilibrium:
Consumer is at point A on budget line BL1 and indifference curve IC1.
2. Price Fall of Good X:
Budget line shifts to BL2 (new affordable combinations), new point C on IC2.
3. Substitution Effect:
Move from A to B (on IC1) along a hypothetical budget line BL* (parallel to BL2 but tangent to IC1).
Shows substitution without income change.
4. Income Effect:
Move from B to C (change due to real income increase), on higher IC2.
✅ Total Change (A to C) = Substitution Effect (A to B) + Income Effect (B to C)
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? 5. Paradoxical Result: Giffen Goods and the Effects
Giffen Goods:
Goods where a price fall leads to lower demand, due to strong negative income effect overpowering substitution effect.
Substitution Effect: Still works normally (increase in demand when price falls).
Income Effect: Negative and large enough to reduce demand (e.g., low-income staple foods like bread).
So, Giffen behavior arises due to:
Strong Negative Income Effect > Substitution Effect
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? 6. Summary: Price Change and its Impact
Effect Price ↓ (Fall) Price ↑ (Rise)
Income Effect ↑ Demand for normal goods (positive) ↓ Demand for normal goods (negative)
↓ Demand for inferior goods (negative) ↑ Demand for inferior goods (positive)
Substitution Effect ↑ Demand for the cheaper good ↓ Demand for the costlier good
Total Effect Both effects usually reinforce each other; except in Giffen case
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✅ Conclusion
Both income and substitution effects are essential to understanding consumer behavior during a price change. Normally, they work together to increase demand when prices fall. But in the case of Giffen goods, a strong negative income effect may dominate, leading to less demand despite a lower price.
