Income and Substitution Effects

Why Does Demand Slope Downward?

When the price of good $x$ falls, quantity demanded rises for two reasons:

1. Substitution effect: $x$ is now relatively cheaper — the consumer substitutes toward $x$ and away from $y$. This effect always increases $x$ (the substitution effect is always negative: price falls, quantity rises).

1. Income effect: the lower price increases real purchasing power — the consumer can afford more of everything. For a normal good, this increases demand for $x$ further. For an inferior good, this decreases demand for $x$ (more income means switching to better alternatives).

Total effect = substitution effect + income effect.

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

Normal good ($\varepsilon_M > 0$): both effects work in the same direction — demand definitely slopes down.

Inferior good ($\varepsilon_M < 0$): the income effect opposes the substitution effect, but the substitution effect usually dominates — demand still slopes down.

Giffen good: the extreme case where the income effect is so strong that it overwhelms the substitution effect — demand slopes upward. This requires the good to be both inferior and a large share of the budget (historically: bread for very poor households). Giffen goods are theoretically possible but extremely rare in practice.

Graphically: the substitution effect is the movement along the original indifference curve to the new price ratio; the income effect is the shift to the new indifference curve at the new prices.

The decomposition table

Tip: The substitution effect never betrays you — cheaper always pulls quantity up along the compensated curve. All the drama lives in the income effect: its sign (normal vs inferior) and its size (Giffen) decide the total.