David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

5.3 Adjustment to price changes
implies a negative relationship between the quantity
demanded of that good and its market price.
y
Inferior goods
Although the substitution effect must reduce the
quantity of meals demanded when the price of meals
increases, the income effect goes in the opposite
direction if the good is inferior: reductions in real
income increase the quantity demanded. We can
even imagine a perverse case in which this effect is
so strong that price rises actually increase the
quantity of that good demanded. Demand curves
then slope upwards! We can use our analysis to
explain how such a paradoxical case can arise.
Consider the case of two different goods, X and Y.
This is represented in Figure 5.15. Suppose that the
price of good X decreases. As usual after a price
change we can decompose the effect of this price
change into substitution and income effects. Suppose
that before the decrease in the price of X the optimal
Income effect Substitution effect
A Giffen good is an inferior good for which the income effect is
positive and larger than the substitution effect (always negative).
Figure 5.15 A Giffen good
choice of the consumer was bundle C on the indifference curve U1 U1• After the price of X decreases, the
budget constraint rotates outwards from AF to AF'. The new choice of the consumer is bundle E on the
indifference curve U2 U2. To show the income and substitution effects, we draw a new budget line HH
parallel to AF' and tangent to the original indifference curve ( U1 U1). By doing this, we identify bundle D.
The movement from C to D is due to the substitution effect. Since the price of X decreased, good Xis now
relatively cheaper than good Y and so the consumer substitutes Y with X. The movement from D to E is
due to the income effect. As income increases, the quantity demanded of good X decreases (from xD to xE).
In this case, Xis an inferior good. For an inferior good, it is always true that income and substitution effects
go in opposite directions. In the particular case considered in Figure 5.15, the income effect is larger than
the substitution effect and the final result is that, after the price of X has decreased, the quantity demanded
of X has decreased (from Xe to xE). In this case, the demand curve of good Xis upward sloping.
A good that has such a property (the income effect is bigger than the substitution effect) is called a Giffen
good, after a nineteenth-century economist who examined whether higher potato prices raised the quantity
of potatoes demanded by the poor.
Notice in Figure 5.15 that, while good Xis a Giffen good, Yis instead a normal good. As income increases,
the quantity demanded of Y increases.
An inferior good need not be a Giffen good. It requires a very strong income effect - here, an increase in demand
in response to real income reductions - to offset the substitution effect that is always negative. When goods
are inferior, theoretical reasoning cannot establish which effect dominates. We must look at the empirical
evidence. After decades of empirical research, economists are convinced that Giffen goods are rare. In practice,
goods are rarely so inferior that the income effect can reverse the substitution effect. This means that, apart
from the rare cases given by Giffen goods, for almost all goods we should have a negative demand curve.
Cross-price elasticities of demand
How does a rise in the price of one good affect demand for other goods? Chapter 4 showed that cross-price
elasticities may be negative or positive. We now illustrate these possibilities, highlighting the roles played
by substitution and income effects.
F'
x
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