Midterm 2.docx - Substitution and Income Effect Giffen good...

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Substitution and Income Effect Giffen good: optimal demand for a good decreases when price falls, and increases when price rises o GIFFEN GOODS MUST BE INFERIOR GOODS o Not all inferior goods are giffen goods Ex.) Price of good decreases has two effects o Substitution effect Good is cheaper so you can consume more of it now o Income effect Lower price so you could consume more of all goods (similar to increase in income) If normal good, consume more If inferior good, consume less Normal Vs Inferior Goods o SUPPOSE PRICE OF GOOD FALLS o Normal goods Increase in demand from substitution effect Increase in demand from income effect Total effect is increase in demand o Inferior goods Increase in demand from substitution Decrease in demand from income effect Total effect may be increase or decrease Substitution Effect o Decrease the price of good and also decrease money income to keep (purchasing power/utility) constant o Slutsky: keep purchasing power constant
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