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M14.L04 β€” Income and Substitution Effects: Normal and Inferior Goods

Module: Module 14 β€” Consumer Choice and Demand Lesson: L04 of 05 Duration: ~30 minutes Level: Intermediate Provenance: MIT OCW 14.01 Principles of Microeconomics | University of Utah Intermediate Microeconomics

Learning Objective

Decompose price effects into income and substitution components.

Effect Decomposition

When p₁ falls: 1. Substitution Effect (SE): Movement along IC to new MRS (always negative) 2. Income Effect (IE): Parallel shift of budget line

For normal goods: SE & IE reinforce (↓p₁ β‡’ ↑x₁) For inferior goods: SE & IE oppose (Giffen if IE dominates)

Australian example: Rice is inferior (↑income β‡’ ↓consumption), while quinoa is normal.

Worked Example

Brisbane Transport Choices

Initial: p₁=\(5 (bus), pβ‚‚=\)20 (Uber), m=$200, U=x₁xβ‚‚ Optimal: x₁*=20, xβ‚‚*=5

After bus fare cut to p₁'=$4: 1. New optimal: x₁'=25, xβ‚‚'=5 2. SE: Find bundle at new prices with original utility (U=100) Solve x₁xβ‚‚=100 s.t. 4x₁+20xβ‚‚=200 β†’ xβ‚Λ’β‰ˆ22.36, xβ‚‚Λ’β‰ˆ4.47 3. SE = 22.36 - 20 = +2.36 4. IE = 25 - 22.36 = +2.64

Common Misconception

"Giffen goods violate the law of demand"

Giffen goods (like cheap staples during Australian gold rushes) are rare but don't violate theory - they're inferior goods where IE > SE.

Key Takeaways

  • Substitution effect always opposes price change
  • Income effect direction depends on good type
  • Slutsky equation: Total Effect = SE + IE
  • Hicksian decomposition holds utility constant
  • Australian Giffen candidates: cheap bread, milk in recessions

Practice

  1. Calculate SE/IE for U=x₁xβ‚‚ when p₁ falls from $6 to \(4 (pβ‚‚=\)12, m=$120)
  2. Draw SE/IE for inferior non-Giffen good
  3. Explain why Sydney housing might show positive IE despite being normal

Further Resources

Provenance: MIT OCW 14.01 Principles of Microeconomics | University of Utah Intermediate Microeconomics