Lecture on Income and Substitution Effects with Giffen Goods

Introduction

• Normal vs. Giffen Goods:
  • Normal Good: Consumption increases when price decreases.
  • Giffen Good: Paradoxical case where consumption decreases when price decreases.

Key Concepts

Normal Good Example

• Axes: Good A (Normal Good) on vertical, Good B on horizontal.
• Price Decrease of Good B: Results in a new budget line.
  • Initial Budget Line: BL1 intersects at specific points.
  • New Budget Line: BL2 shifts due to price decrease of Good B.
• Indifference Curves: Represent consumer's preference and utility maximization.
  • Old indifference curve (IC1) vs. new (IC2).
  • Shift in consumption from initial to final bundle as price decreases.
• Effects:
  • Substitution Effect: Shift from Good A to Good B as B becomes cheaper.
  • Income Effect: Increase in consumption due to increased purchasing power.
  • Both effects in the same direction for normal goods.

Giffen Good Example

• Definition: Special type of inferior good with an income effect that outweighs the substitution effect.
• Scenario: Decrease in the price of Good B.
  • New budget line intersects further on the horizontal axis.
  • New indifference curve illustrates decreased consumption of Good B despite price decrease.
• Effects:
  • Substitution Effect: Positive; shift towards cheaper Good B.
  • Income Effect: Negative; overwhelms substitution effect.
  • Net result: Decrease in consumption of Good B.

Giffen Goods Characteristics

• Example Illustration: Price of heating and behavior change (e.g., vacations).
  • Decrease in heating costs leads to reallocation of income.
• Rarity: Giffen goods are rare; often used as theoretical examples.

Conclusion

• Understanding Income and Substitution Effects helps in analyzing consumer behavior.
• Giffen goods represent a paradox in economic theory.
• Further exploration and questions are encouraged for deeper understanding.