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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).