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Inferior Goods and Giffen Goods- Isolation of Income and Substitution effects - YouTube
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Today, we will discuss the isolation of income
and substitution effects in case of inferior
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goods and Giffen goods. We know that in case
of inferior goods, as the income of the consumer
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rises, the consumption of the good falls.
Do watch the videos on income and substitution
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effects and the explanatory video on inferior
goods and Giffen goods if you haven鈥檛 yet.
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So let鈥檚 move on.
First, let鈥檚 see the income and substitution
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effects in case of an inferior good. The consumer
purchases two goods; food and clothing. The
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consumer is initially at budget line RS and
the optimum bundle of the consumer is at A
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in IC U1. Assume that the price of food falls.
As a result of the fall in price, the budget
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line of the consumer rotates from RS to RT.
The consumer moves to the bundle B at IC U2,
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as a result of the fall in the price of food.
So this movement of the consumer from A to
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B happens as a result of the price effect.
Now, let鈥檚 isolate the price effect into
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income and substitution effect. For that,
draw an imaginary budget line CY. Note that
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CY is drawn parallel to the new budget line
RT and tangential to the initial budget line
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RS. Here, with the imaginary budget line CY,
we are taking away the additional real income
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of the consumer from RT. At the same time,
we are keeping the level of satisfaction of
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the consumer or the relative prices constant
in imaginary budget line CY with regard to
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RT. We can see that the consumer moves to
bundle D as a result of this. Hence the movement
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from B to D is due to the income effect. So
this means that the movement from E to F2
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represents the income effect. This is because
when the real income is taken away from the
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consumer, he moves from B to D. Now, let鈥檚
decipher the substitution effect. So we need
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to know how much the consumer substitutes
one good for another when the price level
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changes. Here, we keep the level of satisfaction
constant at U1. So the substitution effect
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is the movement from A to D ie, as marked
by F1E. The total effect of a price change
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is the addition of income and substitution
effect. We know that in case of an inferior
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good, income effect is negative, as a fall
in income raises the quantity demanded of
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the good. But here, as we can see, the substitution
effect is so strong, as shown by the movement
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from A to D, ie, F1E. So the substitution
effect is dominating the income effect in
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case of an inferior good, as shown in this
example. So the total effect or the price
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effect is substitution effect (F1E) + income
effect (-F2 E) which is F1 F2. Since the substitution
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effect exceeds the income effect, the price
effect is positive. So a decrease in the price
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of food leads to an increase in the quantity
of food demanded in case of inferior goods.
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Now, let鈥檚 move on to the case of Giffen
goods. So here, the consumer is initially
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at budget line CK. His optimum point of consumption
is at A, at IC U1. As a result of a decline
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in the price of food, the consumer moves to
budget line CT, where his optimum point of
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consumption moves to B. So the consumer moves
to a higher IC, U2, as a result of decline
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in the price of food. Now, we draw an imaginary
budget line PK, in order to isolate the income
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and substitution effects. So the consumer
moves to the optimum market basket D at IC
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U1. Let鈥檚 graphically isolate the income
and substitution effect here, as we did in
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the case of inferior goods. The income effect
of the consumer is represented by the movement
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from D to B, that is, shown by EF2. Now let鈥檚
have a look at the substitution effect. It
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is represented by a movement from A to D,
that is, F1E. Here, as we can see, the income
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effect ( EF2) is much larger than the substitution
effect (F1E). As we learned, the Giffen good
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is a special case of an inferior good, where
the income effect is negative. So here, the
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total price effect is income effect +substitution
effect which is -EF2+ F1E which equals -F1F2.
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So here the total effect or price effect is
negative. This means that the decrease in
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the price of food leads to a lower quantity
of food demanded.
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