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Subject 3. Substitution Effect, Income Effect, Normal and Inferior Goods PDF Download
There are two different phenomena underlying a consumer's response to a price drop:

  • As the price of a product declines, the lower opportunity cost will induce consumers to buy more of it since it becomes less expensive - even if they have to give up other products. This is called the substitution effect.

    To isolate this effect diagrammatically, we move the new budget line inwards and parallel until it is tangent to the old indifference curve. The new slope reflects the new relative prices but the utility is the same as it was originally. The substitution effect is Q2Q6. The substitution effect will always lead to more of the relatively cheaper product being demanded.

  • With a fixed amount of money income, a reduction in the price of a product will increase a consumer's real income - the amount of goods and services consumers are able to purchase. Typically, consumers will respond by purchasing more of the cheaper products (as well as other products). This is called the income effect. The income effect is identified by shifting the budget line back outwards again. In this case, this leads to an increase in the quantity demanded of Q6 Q4.

The substitution and income effects will generally work in the same direction, causing consumers to purchase more as the price falls and less as the price rises. The indifference curve can be used to separate these two effects.

In the case of a normal good, higher real income leads to an increase in quantity demanded; this complements the increase due to the substitution effect. This change is shown in the diagram below.

In the case of an inferior product, the income effect leads to a fall in the quantity demanded, which will work against the substitution effect. In the following diagram the substitution effect is Q2 Q5; the income effect is Q5 Q4. However, the substitution effect outweighs the income effect and overall the quantity demanded rises. The overall change in quantity demanded results in an increase of Q2 Q4. This means the demand curve is downward-sloping, because a price fall increases the quantity demanded.

When a good is inferior and the income effect outweighs the substitution effect, it is called a Giffen good. This is, however, unlikely, because the substitution effect is almost always stronger than the income effect.

Another exception is the case where an increase in price causes an increase in demand. This results in an upward-sloping demand curve, and the good is called a Veblen good.

One possible justification for a Veblen good is that people associate higher prices with status, luxury, and quality, so that a higher price might increase the perceived value of a good.

Learning Outcome Statements

b. compare substitution and income effects;

c. distinguish between normal goods and inferior goods;

CFA® 2021 Level I Curriculum, 2021, Volume 2, Reading 12

User Contributed Comments 5

User Comment
anavaza Ver Tabela!
sriera Giffen goods = Moonshine... got it.
niuniucow @sriera-made me lol
choas69 thanks @sriera you made it easier to understand
kingirm Why the axis notations are product a and product b now? Should be product to price I think..
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I just wanted to share the good news that I passed CFA Level I!!! Thank you for your help - I think the online question bank helped cut the clutter and made a positive difference.
Edward Liu

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