Income effect and consumption relationship help

Price Demand Relationship: Normal, Inferior and Giffen Goods

income effect and consumption relationship help

As it has already been explained, income effect depicts the change in the For example, if the consumer's consumption basket includes apples and the price of curve Io on diagram I represents all the combinations between Leisure and. Figure 1. How a Change in Income Affects Consumption Choices. . The two graphs show how budget constraints influence the demand curve. Figure 3. The income effect is the change in consumption patterns due to the change in purchasing power. This can occur from income increases, price.

If income effect alone was working, it would have caused the consumer to buy HT less of good X. But substitution effect is universally present and always induces the consumer to buy more of the relatively cheaper good.

Therefore, the net effect of the fall in price of good X is the increase in quantity demanded by MT. Hence we conclude that in case of inferior goods, quantity demanded varies inversely with price when negative income effect is weaker than the substitution effect.

In other words, even in case of inferior goods having weaker income effect, the demand curve will be downward sloping. Giffen Goods or Giffen Paradox: There is a third possibility. This is that there may be some inferior goods for which the negative income effect is strong or large enough to outweigh the substitution effect. In this case, quantity purchased of the good will fall as its price falls and quantity purchased of the good will rise as its price rises.

In other words, in this case quantity purchased or demanded will vary directly with price. Now, the income effect can be substantial only when the consumer is spending a very large proportion of his income on the good in question so that when price of the good falls, a good amount of income is released. If that good happens to be inferior good, the income effect will be negative as well as strong and may outweigh the substitution effect so that with the fall in price, the consumer will buy less of the good.

Such an inferior good in which case the consumer reduces its consumption when its price falls and increases its consumption when its price rises is called a Giffen good named after the British statistician, Sir Robert Giffen, who in the mid- nineteenth century is said to have claimed that when price of cheap common foodstuff like bread went up the people bought and consumed more bread.

A rise in the price of bread caused such a large decline in the purchasing power of the poor people that they were forced to cut down the consumption of meat and other more expensive food. Since bread even when its price was higher than before was still the cheapest food article, people consumed more of it and not less when its price went up. Similarly, when price of an inferior good, on which people spend a large proportion of their income, falls people will purchase less than before.

This is because the fall in price of an inferior good on which they spend a very large portion of their income causes such a large increase in their purchasing power that creates a large negative income effect.

They will therefore reduce the consumption of that good when its price falls since large negative income effect outweighs the substitution effect. The price-demand relationship in case of a Giffen good is illustrated in Fig.

With a certain given price-income situation depicted by the budget line PL1, the consumer is initially in equilibrium at Q on indifference curve IC1. With a fall in price of the good, the consumer shifts to point R on indifference curve IC2.

income effect and consumption relationship help

It will be seen From Fig. This is the net effect of the negative income effect which is here equal to HN which induces the consumer to buy less of good X and the substitution effect which is equal MH which induces the consumer to buy more of the good. Since the negative income effect HN is greater than the substitution effect MH, the net effect is the fall in quantity purchased of good X by MN with the fall in its price.

Thus, the quantity demanded of a Giffen good varies directly with price. Therefore, if a demand curve showing price-demand relationship of a Giffen good is drawn, it will slope upward. For a good to be a Giffen good, the following three conditions are necessary: It follows from above that, indifference curve analysis enables us to derive a more general law of demand in the following composite form, consisting of three demand theorems to which the Marshallian law of demand constitutes a special case: In the case, a and b the Marshallian law of demand holds good and we get a downward sloping demand curve.

Goods X and Y are normal goods. Positive Income Effect Whenever income of the consumer change, the entire budget constraint shifts outwards or inwards.

income effect and consumption relationship help

With decrease in income the entire budget constraint shifts inwards and it is a parallel shift. Similarly, when income increases then entire budget constraint shifts outwards and it is a parallel shift.

This is shown by budget constraint P2L2 in Figure. When consumer's income decreases, the budget constraint moves inwards.

income effect and consumption relationship help

This is shown by budget constraint P1L1 in Figure. The optimal consumption is located at point e1 at which the consumer buys OX1 units of good X and OY1 units of good Y. Similarly, when consumer's income increases, the budget constraint moves outwards.

Income substitution effect

This is shown by budget constraint P2L2. The optimal consumption is now located at point e2, at which the consumer buys OX2 units of good X and OY2 units of good Y.

Sum Up The curve obtained by joining optimal consumption combinations such as e1, e and e2 is called the income consumption curve ICC. The ICC in Figure. Here income effect is positive for goods X and Y. Negative Income Effect We now study negative income effect. However, we may get to a certain hourly wage, where we can afford to work fewer hours.

Income substitution effect | Economics Help

In the diagram above, after W1, the income effect dominates. It depends on the worker in question. If you are lazy and prefer leisure, higher wages will enable you to work less. The income effect will soon dominate. If you have a lot of debts and spending commitments, the income effect will take a long time to occur.

income effect and consumption relationship help

Income and substitution effect for interest rates and saving Higher interest rates increase income from saving. Therefore, this gives consumers more income to spend, and spending may rise income effect Higher interest rates make saving more attractive than spending, reducing consumer spending substitution effect Related Giffen Goods — where higher price leads to higher demand because of the income effect of price rise, outweighs substitution effect.