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Microeconomic Theory

Notes 2. Separation of Substitution Effect and Income Effect for Inferior Goods

There is an inferior commodity and the income effect as well as substitution effect is negative for this
commodity. The negative income effect means real income increases if the price falls and for this, the
demand is less. The reason behind this is that the consumer demands less inferior goods if the income
increases. So the negative income effect shows that the demand decreases if the price falls. But the
negative substitution effect shows that the demand increases if the price falls. The negative substitution
effect and the negative income effect work in opposite direction. So the demand increases due to negative
substitution effect while the demand decreases due to positive substitution effect. Many inferior goods
have powerful negative substitution effect rather than negative income effect. In this situation,
negative substitution effect is dominant and it neutralizes the income effect. So if the price falls, then
the demand of inferior goods is more than general goods and the demand decreases if the price rises.
(a) Separation of substitution and Income Effect for Inferior Goods in case of Price Rise: If price
rises then how the separation shows in substitution and income effect as below:

Fig. 4.26

Y
Price Effect = SQ
R
Substitution Effect = TQ
Income Effect = (–) TS
L
C
Commodity Y B

A
IC
IC 1
O X
TS N Q P M
Commodity X

In Fig. 4.26, LM is initial budget line. The consumer is in equilibrium on point B on indifference curve
IC. He bought OQ quantity of inferior product X. When the price of product X increases, then the
budget line slopped backwards on LN. The consumer will be in new equilibrium state on point A on
indifference curve IC . On this point, he bought OS units of product X. The movement of point B to
1
A represents the decrease of price effect from OQ to OS. In other words, price effect = OQ – OS = SQ.
The real income would fall if the price of product X falls as shown the sloping of indifference curve
from IC to IC . If we increase the real income of consumer as he stood on initial curve IC, then the new
1
budget line would be RP. This indifference curve touches IC to point C and parallel to line LN. The new
equilibrium point would be C. Thus it means:
(i) Substitution Effect: The movement of initial equilibrium point B to C shows substitution effect.
Both the points are in same indifference curve IC. The change of price due to substitution effect
is shown by the decreasing of OQ to OT. In other words–
Substitution Effect = OQ – OT = TQ

(ii) Income Effect: The income effect is shown by the movement of point C to A. The income effect
is negative for the inferior goods which is shown by–ST. But the negative substitution effect is

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