Difficulty: Introductory-Intermediate | Prerequisites: basic understanding of supply and demand, budget constraints, and utility concepts (Chapters 1–4 of most intro micro textbooks).
Consumer choice theory sits at the heart of introductory microeconomics: it explains how individuals allocate a limited budget across goods to maximise their satisfaction. This set of notes covers how we classify goods by the way demand responds to income changes (normal vs inferior) and how we decompose a price change into two distinct forces, the income effect and the substitution effect. You should already be comfortable with budget lines and indifference curves. If the phrase "tangency condition" does not ring a bell, revisit your Chapter 3/4 notes first.
A normal good is one you buy more of as your income rises; an inferior good is one you buy less of. When a price changes, the total effect on quantity demanded can be split into a substitution effect (you pivot toward the relatively cheaper good) and an income effect (the price change makes you effectively richer or poorer). Whether these two effects reinforce or oppose each other determines the shape of the demand curve.
Normal good
A good whose quantity demanded increases when consumer income rises, holding prices constant. Think of it as: the stuff you buy more of once you get a raise.
Inferior good
A good whose quantity demanded decreases when consumer income rises. In simple terms, this means goods you trade away from as you can afford better alternatives (e.g. instant noodles, bus rides).
Income effect
The change in quantity demanded that results purely from the change in a consumer's purchasing power after a price change. Think of it as: the price drop made you "richer," so you adjust your basket accordingly.
Substitution effect
The change in quantity demanded that results purely from the change in relative prices, holding utility constant. In simple terms, this means you pivot toward whichever good just became relatively cheaper.
Indifference curve
A curve showing all combinations of two goods that give a consumer the same level of utility (satisfaction). Think of it as: every point on the curve makes you equally happy.
Budget line (budget constraint)
A line showing all combinations of two goods a consumer can afford given their income and the prices of both goods. In simple terms, this means the boundary of what your wallet allows.
Perfect complements
Goods that are always consumed together in fixed proportions. Indifference curves are L-shaped. Think of it as: left shoes and right shoes.
Perfect substitutes
Goods the consumer is willing to trade at a constant rate. Indifference curves are straight lines. Think of it as: two brands of bottled water that taste identical to you.
Engel curve
A graph showing the relationship between consumer income and the quantity demanded of a good. Upward-sloping for normal goods, downward-sloping for inferior goods.
The problem set presents a graph plotting vehicles per 1,000 people against per-capita income (real $ PPP) for the USA, Germany, Japan and South Korea from 1960 to 2002.
As income rises for every country in the data, vehicle ownership also rises. This positive relationship tells us vehicles are a normal good.
If vehicles were an inferior good, the graph would slope downward: as income grew, people would buy fewer vehicles and substitute toward other transport.
The curve follows a Gompertz S-shape, meaning ownership accelerates at low incomes, then levels off at high incomes (saturation). This flattening does not make vehicles inferior; it means the income elasticity is declining but still positive.
When the price of Good 1 falls, the budget line pivots outward from BL1 to BL2. The total change in consumption can be split into two parts:
Substitution effect (SE): Slide along the original indifference curve to a point where the marginal rate of substitution equals the new price ratio. The consumer substitutes toward the now-cheaper good. This effect is always in the direction of consuming more of the good whose price fell.
Income effect (IE): Shift from the compensated (Hicksian) bundle to the new optimum on BL2. This captures the gain in real purchasing power. For a normal good, the income effect reinforces the substitution effect. For an inferior good, it works against it.
The consumer starts at a tangency on BL1, moves along the original indifference curve to a compensated point (substitution effect, E1 to E2 region), then shifts to the new tangency on BL2 (income effect).
Both effects increase consumption of Good 1, so you see a clear rightward movement along the x-axis.
With L-shaped curves, the consumer always chooses the corner of the L. There is no substitution effect because the consumer cannot trade one good for the other while staying on the same indifference curve.
The entire change in consumption comes from the income effect alone. E3 marks the new corner at the higher budget.
With straight-line indifference curves, the consumer picks a corner solution on whichever axis gives more utility per pound spent.
If the price of Good 1 falls enough that its "bang per buck" now exceeds Good 2's, the consumer jumps entirely to Good 1. The substitution effect can be dramatic (all-or-nothing), and the income effect may shift the corner further out along the axis.
Hicksian decomposition (graphical method):
Start at the original optimum on BL1.
Draw a hypothetical budget line parallel to BL2 (same new price ratio) but tangent to the original indifference curve. The movement from the original bundle to this tangency is the substitution effect.
The movement from the hypothetical tangency to the actual new optimum on BL2 is the income effect.
Total effect = Substitution effect + Income effect
Budget line equation:
P1 * X1 + P2 * X2 = I
where P1, P2 are prices and I is income. A fall in P1 pivots the budget line outward along the X1 axis (the X2 intercept stays put, the X1 intercept increases).
Engel curve slope:
Positive slope: normal good (more income, more quantity).
Negative slope: inferior good (more income, less quantity).
"A flattening Engel curve means the good has become inferior." No. A declining slope means the income elasticity is falling (you are approaching saturation), but as long as the slope is positive, the good is still normal.
"The substitution effect can go in either direction." For a standard price decrease, the substitution effect always pushes the consumer toward more of the cheaper good. It is the income effect whose direction depends on whether the good is normal or inferior.
"Perfect complements have a substitution effect of zero because the goods are consumed together." The reasoning is right but worth stating precisely: the L-shaped indifference curve means there is no tangency to slide along, so the compensated bundle is the same corner point. The entire observed change is income effect.
"Income and substitution effects are directly observable." They are not. The decomposition is a theoretical construct. You observe only the total effect; the split requires constructing a hypothetical (compensated) budget line.
⚠️ Exams love asking you to identify normal vs inferior from a graph or data table. Look at the direction of the income-quantity relationship.
⚠️ You will almost certainly be asked to decompose a price change into income and substitution effects on a diagram. Practise drawing the compensated budget line (parallel to BL2, tangent to the original indifference curve).
⚠️ Perfect complements and perfect substitutes are favourite special cases. Know that perfect complements have zero substitution effect and perfect substitutes can have an all-or-nothing substitution effect.
⚠️ Be ready to explain, in words, why the substitution effect is always negative (more of the good whose price fell) while the income effect's sign depends on whether the good is normal or inferior.
True or False: If vehicle ownership rises with income, vehicles are a normal good. (True)
Fill in the blank: The substitution effect always moves the consumer toward more of the good whose price has ______. (fallen/decreased)
True or False: For perfect complements, the substitution effect is zero. (True)
Fill in the blank: An inferior good has a ______ sloping Engel curve. (downward/negatively)
True or False: The income effect for a normal good reinforces the substitution effect when the price of the good falls. (True)
Q: Based on a graph showing that vehicle ownership rises with per-capita income across countries, are vehicles a normal or inferior good? What would the graph look like if the opposite were true?
A: Vehicles are a normal good because quantity demanded (vehicles per 1,000 people) increases with income. If vehicles were inferior, the curve would slope downward: higher income would correspond to fewer vehicles per capita.
Q: In a diagram with smooth convex indifference curves, the price of Good 1 falls and the budget line shifts from BL1 to BL2. Describe how to identify the substitution and income effects.
A: Draw a compensated budget line parallel to BL2 (reflecting the new price ratio) but tangent to the original indifference curve. The movement from the original bundle to the tangency on this compensated line is the substitution effect. The movement from that compensated tangency to the new optimum on BL2 is the income effect.
Q: Why is the substitution effect zero for perfect complements?
A: Perfect complements have L-shaped indifference curves. The optimal bundle is always at the corner of the L. Sliding along the indifference curve at the new price ratio still lands you at the same corner, so there is no change in quantities from the substitution effect alone. The entire change comes from the income effect.
Q: A consumer treats two goods as perfect substitutes. The price of Good 1 drops. Describe what happens to consumption.
A: If the price fall makes Good 1 cheaper per unit of utility than Good 2, the consumer switches entirely to Good 1 (corner solution). The substitution effect is the entire shift in consumption from Good 2 to Good 1. The income effect then allows the consumer to buy more of Good 1 along the axis.
This material connects directly to price elasticity of demand (covered in the next set of notes): the relative sizes of income and substitution effects influence how elastic demand is. It also connects to Giffen goods, a rare special case where an inferior good's income effect is so large it overwhelms the substitution effect, producing an upward-sloping demand curve. You will see this in the utility maximisation notes (Document 3 of this series).
Normal good, inferior good, income effect, substitution effect, Hicksian decomposition, Slutsky decomposition, indifference curve, budget line, budget constraint, perfect complements, perfect substitutes, L-shaped indifference curves, linear indifference curves, Engel curve, Gompertz function, vehicle ownership, corner solution, interior solution, compensated demand, real income, purchasing power, consumer choice theory, microeconomics problem set 3, NYU intro micro