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).