The Nature of Substitution Effect and Income Effect for Inferior Goods and Giffen Goods from Slutsky Equation

The Slutsky equation is an economic concept that allows us to decompose the overall effect of a price change into two separate components: the substitution effect and the income effect. This equation helps us understand the nature of these effects for different types of goods, including inferior goods and Giffen goods.

1. Substitution Effect:
The substitution effect measures the change in quantity demanded of a good that results from a change in its relative price while keeping real income constant. It reflects the substitution of a relatively cheaper good for a relatively more expensive good.

For inferior goods, the substitution effect is negative. As the price of an inferior good decreases, consumers tend to substitute it with a superior good. This is because inferior goods are associated with lower quality or status, and as consumers' income increases, they prefer to purchase higher-quality alternatives. Therefore, the substitution effect for inferior goods reinforces the negative income effect.

For Giffen goods, the substitution effect is positive. Giffen goods are special types of inferior goods that have a unique demand relationship. As the price of a Giffen good increases, consumers are forced to consume more of it due to income constraints. In this case, the substitution effect offsets the negative income effect, leading to a positive overall effect on the quantity demanded.

2. Income Effect:
The income effect measures the change in quantity demanded of a good that results from a change in real income, assuming relative prices remain constant. It reflects the impact of changes in purchasing power on consumer demand.

For inferior goods, the income effect is negative. When consumers' income increases, they tend to buy fewer inferior goods and shift their preferences towards superior goods. This is because higher income allows consumers to afford better-quality alternatives, reducing the demand for inferior goods.

For Giffen goods, the income effect is positive. As the price of a Giffen good increases, consumers' purchasing power decreases, forcing them to allocate a larger proportion of their income to the Giffen good. This positive income effect outweighs the negative substitution effect, leading to an overall increase in the quantity demanded.

In summary, the nature of the substitution effect and income effect for inferior goods and Giffen goods can be understood through the Slutsky equation. The substitution effect is negative for inferior goods and positive for Giffen goods, while the income effect is negative for both inferior goods and Giffen goods. However, the income effect for Giffen goods is stronger, resulting in an overall positive effect on the quantity demanded.