# Income and Substitution Effects

Business I · Microeconomics · https://tryals.app/learn/business-i/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.

| Good type | Substitution | Income | Total Effect ||
| --- | --- | --- | --- |
| **Normal** ($\varepsilon_M > 0$) | Positive | Positive | Strongly positive |
| **Inferior** ($\varepsilon_M < 0$) | Positive | Negative | Positive (usually) |
| **Giffen** | Positive | Very negative | **Negative** (Law breaks) |

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.

## Practice questions

5 of this lesson's 13 practice questions, with answers. The full set is in the app.

### 1. The substitution effect always pushes consumption of a cheapened good upward, and the income effect can push either way. Why the asymmetry?

A. Substitution is defined at constant purchasing power
B. The income effect is smaller, so its direction matters less
C. Substitution effects are measured empirically and income effects theoretically
D. The income effect is always negative, which offsets the substitution effect

**Answer:** A. Substitution is defined at constant purchasing power

**Why:** Compensating away the income change leaves only the relative-price tilt, which has one possible direction by construction. The income effect asks whether the good is one you buy more or less of as you get richer, which is why inferior goods open the theoretical door to a Giffen good.

Page: https://tryals.app/practice/business-i/income-and-substitution-effects/the-substitution-effect-always-pushes-consumption-of-a-cheapened-good

### 2. The income effect of a price decrease always increases the quantity demanded of the cheaper good.

**Answer:** False

**Why:** False. The **substitution** effect is unambiguous; the *income* effect can go either way. A price fall raises real income, and for an inferior good that reduces demand, with a Giffen good the income effect outweighs the substitution effect and the demand curve slopes upward.

Page: https://tryals.app/practice/business-i/income-and-substitution-effects/the-income-effect-of-a-price-decrease-always-increases-the-quantity

### 3. Sort into normal goods vs inferior goods.

**Answer:**

- Normal good: Organic food (demand rises with income), International travel
- Inferior good: Instant noodles (replaced by better meals as income rises), Bus transport (replaced by car as income rises)

**Why:** Normal goods: demand rises with income. Inferior goods: demand falls as consumers upgrade to better alternatives.

Page: https://tryals.app/practice/business-i/income-and-substitution-effects/sort-into-normal-goods-vs-inferior-goods

### 4. For a Giffen good, demand rises when the price rises. Why does that not refute the law of demand?

A. Because the price rise must have been accompanied by a change in preferences
B. Because Giffen goods do not actually exist in real markets
C. Because the law describes the substitution effect alone
D. Because the law of demand applies only to normal goods by definition

**Answer:** C. Because the law describes the substitution effect alone

**Why:** Slutsky is what makes the anomaly legible. A price rise on a staple consuming much of a poor household’s budget makes it poorer, and the income effect on an inferior good can dominate.

Page: https://tryals.app/practice/business-i/income-and-substitution-effects/for-a-giffen-good-demand-rises-when-the-price-rises-why-does-that

### 5. Match each concept to its definition.

**Answer:**

- Substitution effect → Response to relative price change (always toward cheaper good)
- Income effect → Response to change in real purchasing power
- Normal good → Demand rises with income
- Inferior good → Demand falls with income

**Why:** Substitution is about relative prices; income is about purchasing power. Their combination determines the demand slope.

Page: https://tryals.app/practice/business-i/income-and-substitution-effects/match-each-concept-to-its-definition