Income and Substitution Effects

The Two Forces of Price Change

When a price falls, quantity demanded rises due to two distinct economic forces acting at the same time.

Substitution effect: As good $x$ becomes relatively cheaper, the consumer substitutes toward $x$ and away from $y$. This effect always increases $x$, meaning price drops always push quantity up along the compensated curve.

Income effect: A lower price increases real purchasing power, letting the consumer afford more of everything. For a normal good, this increases $x$ further; for an inferior good, it decreases demand.

Total effect = substitution effect + income effect.

$$\Delta x^* = \underbrace{\Delta x^s}_{\text{substitution}} + \underbrace{\Delta x^n}_{\text{income}}$$

Graphically, the substitution effect is the movement along the original indifference curve to the new price ratio, while the income effect is the shift to the new indifference curve at those new prices.

Good Types and the Giffen Exception

All drama lives in the income effect: its sign (normal vs inferior) and size decide the total direction of demand.

A Giffen good is the extreme case where the income effect overwhelms the substitution effect, making demand slope upward. This requires the good to be inferior and a massive share of the budget. Giffen goods are theoretically possible but extremely rare.