Indifference Curves and Giffen Goods

Popular question either in the multiple-choice or the essay paper at A2 level. A giffen good occurs when a rise in price causes higher demand because the income effect outweighs the substitution effect.

Suppose you have a very low income and eat two basic food stuffs rice and meat. Meat is a luxury and is much more expensive than rice. If rice increased in price, your disposable income is effectively reduced significantly therefore, you buy less meat, to compensate for less meat you buy more rice to gain enough calories. Source: www.economicshelp.org

Griffen good and indifference curves

indiff-giffen

  • Good B falls in price – hence budget line moves from: 50 A – 30 B to: 50 A – 60 B.
  • The move from point J to point K is the substitution effect which = +16
  • The move from point K to point L is the income effect which = -20
  • These make up an overall move from point J to point L is the price effect (substitution effect + income effect) = -4

As income effect is negative, substitution effect positive and overall price effect negative Good B is a giffen good.

Summary of income and substitution effects of price changes

sub-income-effect

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Indifference Curves. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

A2 Economics – Indifference curves and GIN

With the A2 essay paper next week here is a note on indifference curves – if you know the theory it is a good essay to do. Remember that most indifference curve questions will have a discussion section that asks for the limitations of such theory.

Last year one student has come up with a novel way of remembering the position of the indifference curve when the price of one good falls. The three types of goods that eventuate from a price fall are: Giffen, Inferior and Normal – GIN.

G – Giffen – price falls negative income effect outweighs the positive substitution effect – point L would then be to the left of point J on the graph below.
I – Inferior – price falls positive substitution effect outweighs negative income effect – point L would then be between points J and K
N – Normal good – price falls both income and substitution effect are positive – point L will be to the right of point K – as shown below.

Below is a mindmap on indifference curves explaining all the effects of increasing and decreasing prices on different types of goods.

A2 Economics – Indifference Curves – Mindmap

With the A2 multiple-choice paper not too far away here are some notes on indifference curves – there is usually a question on either the income effect or substitution effect. The video below is particularly useful.

Income and Substitution Effects with Indifference Curves
Any price change can be conveniently analysed into 2 separate effects – the INCOME EFFECT and the SUBSTITUTION EFFECT.

Income effect of a price change: – when there is a fall in the price of a product, the consumer receives a real income effect and is able to buy more of this and other products in spite of the fact that nominal income is unchanged. If the consumer buys more of the good when the price falls it is a Normal good. If the consumer buys less of the good when the price falls it is seen as an Inferior good.

Substitution effect of a price change: – when there is a rise or fall in the price of a product, the consumer receives a decrease or an increase in the utility derived from each unit of money spent on the product and therefore rearranges demand to maximise utility. This is distinct from the income effect of a price change. For all products, the substitution effect is always positive such that a fall in price leads to an increase in demand as consumers realise an increase in the satisfaction they derive from each unit of money spent on the product.

Remember for normal goods, both the income and substitution effects are positive. But the income effect can be negative: if a negative income effect outweighs the positive substitution effect, this means that less is bought at a lower price and vice-versa. This good is therefore known as a Giffen good.

Giffen goods are generally regarded as goods of low quality which are important elements in the expenditure of those on low incomes. A good example is a basic food such as rice, which forms a significant part of the diet of the poor in many countries. The argument, not accepted by all economists, is that when the price of rice falls sufficiently individuals’ real income will rise to an extent that they will be able to afford more attractive substitutes such as fresh fruit or vegetables to makeup their diet and as a result they will actually purchase less rice even though its price has fallen.

Indifference Curves – Mindmap

With a bit more time on my hands I was able to produce a mindmap on Indifference Curves – a topic that students find quite difficult. The mindmap covers all the main features – what is meant by the Income Effect, Substitution Effect and most importantly how they are characterised in Normal, inferior and Giffen goods. Particularly useful for a theoretical essay on utility and consumer choice. You can download a full size copy by clicking here.

Mind Map 13 indifference curves.jpg

Income and Substitution Effects with Indifference Curves

New to the Cambridge A Level Economics syllabus this year in Indifference Curve analysis and I have just covered this with my A2 class. Below are some notes that I’ve put together and a very good video from economicsfun on YouTube.

Income and Substitution Effects with Indifference Curves

Any price change can be conveniently analysed into 2 separate effects – the INCOME EFFECT and the SUBSTITUTION EFFECT.

Income effect of a price change: – when there is a fall in the price of a product, the consumer receives a real income effect and is able to buy more of this and other products in spite of the fact that nominal income is unchanged. If the consumer buys more of the good when the price falls it is a Normal good. If the consumer buys less of the good when the price falls it is seen as an Inferior good.

Substitution effect of a price change: – when there is a rise or fall in the price of a product, the consumer receives a decrease or an increase in the utility derived from each unit of money spent on the product and therefore rearranges demand to maximise utility. This is distinct from the income effect of a price change. For all products, the substitution effect is always positive such that a fall in price leads to an increase in demand as consumers realise an increase in the satisfaction they derive from each unit of money spent on the product.

Remember for normal goods, both the income and substitution effects are positive. But the income effect can be negative: if a negative income effect outweighs the positive substitution effect, this means that less is bought at a lower price and vice-versa. This good is therefore known as a Giffen good.

Giffen goods are generally regarded as goods of low quality which are important elements in the expenditure of those on low incomes. A good example is a basic food such as rice, which forms a significant part of the diet of the poor in many countries. The argument, not accepted by all economists, is that when the price of rice falls sufficiently individuals’ real income will rise to an extent that they will be able to afford more attractive substitutes such as fresh fruit or vegetables to makeup their diet and as a result they will actually purchase less rice even though its price has fallen.

Income and Substitution Effects with Indifference Curves

New to the Cambridge International Exams A Level Economics syllabus is indifference curve analysis. This was part of the old Oxford and Cambridge A Level Economics course back in the 1990’s. Below are some notes which might be of assistance to those teaching this course.

Income and Substitution Effects with Indifference Curves

Any price change can be conveniently analysed into two separate effects – the income effect and the substitution effect.

Income effect of a price change: when there is a fall in the price of a product, the consumer receives a real income effect and is able to buy more of this and other products in spite of the fact that nominal income is unchanged. If the consumer buys more of the good when the price falls it is a normal good. If the consumer buys less of the good when the price falls it is seen as an inferior good.

Substitution effect of a price change: when there is a rise or fall in the price of a product, the consumer receives a decrease or an increase in the utility derived from each unit of money spent on the product and therefore rearranges demand to maximise utility. This is distinct from the income effect of a price change.  For all products, the substitution effect is always positive so a fall in price leads to an increase in demand as consumers realise an increase in the satisfaction they derive from each unit of money spent on the product.

Note for normal goods, both the income and substitution effects are positive. But the income effect can be negative; if a negative income effect outweighs the positive substitution effect, this means that less is bought at a lower price and vice-versa. This good is known as a giffen good.

Showing income and substitution effects on a diagram

A Normal Good

Indiff Curves - Noraml Good

The graph above shows the effect of a fall in the price of Good B that increases the amount that can be purchased to 70. Hence the budget line moves from: 45 A – 37 B to: 45 A – 70 B.

To find the substitution effect, you must find a point where the new level of prices is effective but the consumer is no better or worse off than before. Therefore a line ZZ is drawn parallel to the new budget line (45A – 70B) and therefore has the same slope. This line then gives the same relative prices as implied by the new budget line. The consumer will be no better or worse off if he is consuming on his original indifference curve I1. Drawing the line ZZ at a tangent to the indifference curve I1, the consumer would consume at point K if prices had changed but income had not. The movement from point J to point K is therefore the substitution effect of the price change.

To find the income effect you have to find the movement between two points where income has changed but the same relative prices are effective. The movement from point K to point L is the income effect of the price change.

Summary

  • Good B falls in price – hence budget line moves from: 45 A – 37 B to: 45 A – 70 B.
  • The move from point J to point K is the substitution effect which = +13
  • The move from point K to point L is the income effect which = +10
  • These make up an overall move from point J to point L is the price effect (substitution effect + income effect) = +23
  • As both effects are positive Good B is a Normal good

Go to eLearn Economics for more notes on Indifference Curves.