Substitution and Income Effects: Normal vs Inferior Goods | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Welcome back as we compare substitution and income effects, and also dive deeper into normal versus inferior goods.

Substitution and Income Effects

We have learned in the first lesson that the law of demand states that when the own price of a good falls and all else are equal, the demand for the good increases. According to this law, the demand curve for any good is downward sloping. We can attribute this to two effects – the substitution effect, and the income effect.

Substitution Effect

Let’s say a family has a weekly meal budget for 3 Whoppers, 3 Big Macs, and 1 steak. The subject that we are analyzing here is the demand for Big Mac. If the price of Big Mac falls and the prices of the other two remain the same, the family may substitute some of the Whoppers for Big Macs. This is known as the substitution effect, which always leads to greater consumption of the good that has fallen in price.

Income Effect

The second effect is the income effect. Over here, it does not refer to the income of the family, but rather the change in real income, which refers to purchasing power. As the price of Big Macs has fallen, the family now has extra cash to spend. A positive income effect is when the family uses this extra cash to buy more Big Macs. So as you can see, the family’s consumption of Big Macs has doubled to 6 per week due to the drop in price under this scenario.

However, the income effect can also be negative. A negative income effect is when the family buys fewer Big Macs and buys more steaks, as it can now afford to spend on more steaks.

Normal vs Inferior Goods

So what determines whether the income effect for a good is positive or negative? It depends on whether the good is a normal good or an inferior good. If Big Mac is a normal good, the income effect will be positive. If Big Mac is an inferior good, the income effect will be negative.

However, one thing you have to note is that this in turn depends on the type of consumer we are referring to. For example, in our last lesson, the low-income family regards a Big Mac as a normal good. When the household income increases, they consume more Big Macs.

On the contrary, to a middle or high-income family, a Big Mac can be regarded as an inferior good. When their income rises, they may want to spend more on more expensive food options and avoid fast food.

Outcomes When the Price of a Good Decreases

So in summary, there are 3 possible outcomes when the price of a good decreases:

1. If the substitution effect and income effect are both positive, the consumption of the good will increase.
2. If the substitution effect is positive, but the income effect is negative but smaller than the substitution effect, the consumption of the good will also increase.
3. If the negative income effect is greater than the substitution effect, the net consumption of the good will decrease.

Exceptions to the Law of Demand

The third possible outcome is if the negative income effect is greater than the substitution effect. In this case, the net consumption of the good will decrease. Now, if we plot the demand curve of the last outcome, we get an upward sloping straight line. When the price goes down, the demand goes down. This is an exception to the law of demand. We call this a Giffen good, which is an inferior good for which the negative income effect outweighs the positive substitution effect when the price falls. Although a Giffen good is only in theory, there are some rare instances where this turned out to be true.

Another exception where the demand curve is upward sloping is the Veblen good, for which a higher price makes the good more desirable. This is usually the case for some luxury goods, like Hermes bags, where the higher price conveys higher status to the owners. As such, this upward sloping curve only applies to a select group of people who can afford it, and there has to be a limit to it, otherwise the price would just rise infinitely.

Conclusion

And that concludes this lesson on the substitution and income effects. In our next lesson, we shall move on to supply analysis.