Some Basics on the Income and Substitution Effect

We all know that when the price of a good goes up we buy less of that good. This is the principle behind Mmmm ... Chocolicious the downward sloping demand curve–as price increases, the quantity consumed goes down (or vice versa). It makes perfect sense, but where does it come from, and can we dive a little deeper into the issue? To do so, we need to discuss two ‘effects’: the substitution effect and the income effect. Together these two effects create what economists call the ‘Law of Demand,’ namely that as a good gets more expensive, we consume less of it.

Consider the case of a typical consumer, Shana. For simplicity, Shana spends all of her money on two things, cookies and a composite good consisting of all other goods (AOG). According to the relative prices of the two goods (the slope of the budget constraint), and her preferences (the slope of her indifference curves), Shana will buy some bundle of cookies and AOG at the point where the amount of utility she would gain from one more cookie exactly matches the amount she would have to pay for that cookie in terms of giving up one more unit of AOG. In other words, the rate at which Shana is willing to trade cookies for AOG must exactly match the rate at which she is able to trade cookies and AOG–the point where the budget line and the indifference curves are tangent.

Now to the substitution and income effects. What happens if there is a price change? Let’s say, for example, the price of cookies goes up due to a tragic, but inevitable, Girl Scout strike. As you might expect, two things happen. First, the price of cookies relative to AOG goes up. This means that when Shana considers her next purchase of cookies, since cookies as more expensive than before, she has to give up more of all other goods in order to buy cookies. Because the relative price has changed, she will buy fewer cookies–this is the substitution effect.

Second, since the price of cookies has increased, Shana has less money to spend on everything. In other words as prices increase, the number of different possible combinations of cookies and AOG that she is able to buy decreases. Shana is poorer because the price of a good she consumes has gone up. Because she is poorer, she buys fewer cookies. This is the income effect. Note that there is a possibility that as she gets poorer, her income effect actually shows that she buys more cookies. This is the case of inferior goods–goods you buy more of as you get poorer (such as Ramen Noodles and Schlitz Beer). As long as the substitution effect (which causes Shana to buy fewer cookies) is greater then the income effect (which says Shana could buy more or fewer cookies) then we will have a downward sloping demand curve. That’s all there is to it.

Now, a quizzical mind might ask what happens if the good is very, very inferior, i.e. the income effect dominates the substitution effect in opposite directions? Wouldn’t that means that even though the cookies got more expensive Shana is buying more of them? Isn’t that a violation of the downward sloping demand curve? Wouldn’t this mean an upward sloping demand curve? Why, yes it would. This theoretical possibility is called a Giffen good, after 19th century researcher Robert Giffen, who pointed this possibility out in regards to potatoes in the Irish potato famine. I want to stress that this is simply a theoretical possibility, and no matter how hard people try, no credible Giffen goods exist.

So, to sum up. As the price of a good goes up, the substution effect component of the change in demand shows that we buy less of the good. The income effect component says we buy less in the case of normal goods and more in the case of inferior goods. As long as the substitution effect and the income effect move in the same direction, or if the income effect is smaller than the substitution effect, the result is a downward sloping demand curve, just like we observe in real life.