Income and Substitution Effects
A fall in the price of a good has two effects:
1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive.
2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power.
Substitution effect – Change in consumption of a good associated with a change in its price, with the level of utility held constant.
Income effect – Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant.
Total Effect = Substitution Effect + Income Effect
Inferior good – A good that has a negative income effect.
Giffen good – Good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect.
