101 Concepts for the Level I Exam

Concept 18: Substitution and Income Effects

Substitution effect

When a good’s price falls, due to substitution effect consumers buy more of this good as compared to other goods for which the prices have remained the same.
Substitution effect is always positive.

Income effect

When a good’s price falls, real income rises.
If the good is a normal good, the income effect will be positive and more of this good will be purchased.
If the good is an inferior good, the income effect will be negative and less of this good will be purchased.

Giffen goods

Giffen goods are highly inferior for which the negative income effect outweighs the positive substitution effect.
Therefore even though price falls, the quantity demanded still decreases.
Giffen goods have a positively sloped demand curve (which means that as price decreases the quantity demanded also decreases).

Veblen goods

Veblen goods are “high status” goods.
If price increases, this makes the goods even more desirable and quantity demanded increases.
Veblen goods also have a positively sloped demand curve (which means that as price increases the quantity demanded also increases).