Teaching my A2 class the most complex theory in the A2 CIE Economics course – indifference curves. This 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.
With the A2 exam on Wednesday next week here are some notes on indifference curves – it is a good essay to do if you know the theory. 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 Normalgood. If the consumer buys less of the good when the price falls it is seen as an Inferiorgood.
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.
New to the A2 CIE syllabus is indifference curves and my A2 class recently had a multiple-choice question concerning indifference curves and giffen goods. 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
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