Income and Substitution Effects with Giffen Goods

Overview

This lecture explains income and substitution effects using a Giffen good example, contrasting it with normal goods in a two-good economy.

Good A is a normal good (vertical axis); Good B is initially considered normal (horizontal axis).
Decreasing the price of Good B shifts the budget line outward, allowing more of Good B to be bought.
Consumption of Good B increases as its price falls, which is typical for normal goods.
The substitution effect: as Good B becomes cheaper relative to Good A, consumers buy more of B, less of A.
The income effect: the lower price of B makes consumers effectively richer, leading to increased consumption of both goods if both are normal.

Good B is now a Giffen good—an inferior good with an income effect that outweighs the substitution effect.
For a Giffen good, decreasing its price leads to a decrease in its consumption, contrary to normal expectations.
The budget line shifts outward as before, but the new consumption bundle for Good B is lower due to the dominant negative income effect.
The substitution effect (always positive—more Good B when its price falls) is still present but smaller than the negative income effect.
Giffen goods are rare and appear in special cases where the income effect overpowers the substitution effect.

Substitution effect is shown by keeping utility constant and only changing relative prices (parallel budget shift).
Income effect is the movement from the hypothetical bundle (same utility, new prices) to the final bundle (higher utility, new prices).
In Giffen goods, the negative income effect is greater than the positive substitution effect, leading to less consumption as price drops.

Classic examples: Potato famine, heating costs and vacation spending.
When key necessities get cheaper, consumers may spend less on them if extra income lets them buy alternatives (e.g., vacationing instead of heating).
Giffen goods are very rare and have counter-intuitive demand responses.

Normal Good — a good for which demand increases when income increases.
Inferior Good — a good for which demand decreases when income increases.
Giffen Good — an inferior good where the income effect is so strong and negative that demand decreases as its price falls.
Substitution Effect — the change in consumption due to a good’s price change, holding utility constant.
Income Effect — the change in consumption due to the change in real income from a price change.

Review graphical analysis of income and substitution effects for normal and Giffen goods.
Reflect on why Giffen goods are rare and the necessary conditions for their existence.