Difficulty: Intermediate | Prerequisites: Indifference curves, budget constraints, basic price elasticity of demand.
When a good's price changes, two things happen simultaneously: the good becomes relatively cheaper or more expensive compared to other goods (the substitution effect), and the consumer's real purchasing power shifts (the income effect). For most goods these two effects push in the same direction, which is why demand curves slope downward. Giffen goods are the rare theoretical case where the income effect is so strong and works in the opposite direction that it overwhelms the substitution effect, producing an upward-sloping demand curve. Understanding the decomposition of these effects is essential for consumer theory and is one of the more demanding graphical exercises in introductory microeconomics.
Every price change can be split into a substitution effect (consumers switch towards the relatively cheaper good) and an income effect (the change in real purchasing power shifts demand). For normal goods, both effects reinforce each other. For a Giffen good, the income effect is so large and runs in the opposite direction that the consumer buys more of the good when its price rises.
Substitution effect
The change in quantity demanded that results purely from the change in relative prices, holding the consumer's utility (satisfaction) constant. It always works in the standard direction: when a good's price rises, the substitution effect reduces the quantity demanded of that good.
Income effect
The change in quantity demanded that results from the change in the consumer's real purchasing power caused by the price change. A price increase makes the consumer effectively poorer. For a normal good, this reduces quantity demanded; for an inferior good, it increases it.
Giffen good
A special case of an inferior good where the income effect is so large that it dominates the substitution effect. The result: when the price rises, the consumer buys more of the good. The demand curve slopes upward. Think of it as a good so central to a very poor consumer's budget that a price rise squeezes them into buying even more of it (and less of everything else).
Compensated (Hicksian) demand
The demand curve that holds utility constant rather than income constant. It isolates the substitution effect and always slopes downward.
Composite good (Y)
A stand-in for "everything else the consumer buys," measured in units of money. Placed on the vertical axis by convention in two-good diagrams.
Indifference curve
A curve showing all combinations of two goods that give the consumer the same level of satisfaction. Convex to the origin, does not cross other indifference curves.
Budget line (budget constraint)
A straight line showing all combinations of two goods the consumer can afford given their income and the prices of the goods. A price change for one good pivots the budget line around the intercept of the other good.
When the price of good X rises, X becomes relatively more expensive compared to good Y.
The substitution effect always pushes the consumer to buy less X and more Y. This holds for every type of good, including Giffen goods.
Graphically, you isolate the substitution effect by drawing a compensating budget line: shift the new (steeper) budget line outward until it is tangent to the original indifference curve. The movement along the original indifference curve from the original bundle to this tangency point is the substitution effect.
A price increase for X reduces the consumer's real purchasing power (the budget set shrinks).
For a normal good, this reduction in real income leads the consumer to buy less X. The income effect reinforces the substitution effect.
For an inferior good, the reduction in real income leads the consumer to buy more X. The income effect works against the substitution effect.
For most inferior goods, the substitution effect still dominates, so the demand curve still slopes downward.
A Giffen good is an inferior good where the income effect is so powerful that it overwhelms the substitution effect.
Total effect of a price increase = substitution effect (buy less X) + income effect (buy more X, since X is inferior and the consumer is now effectively poorer).
If |income effect| > |substitution effect|, the total effect is that the consumer buys more X when its price rises.
This produces an upward-sloping demand curve.
The conditions for this are quite restrictive: the good must be inferior, it must take up a large share of the consumer's budget, and the consumer must be quite poor. The classic textbook example is a staple food (rice, potatoes) for a very low-income consumer.
The exam asks you to show this on an indifference-curve/budget-line diagram with good X (Giffen good) on the horizontal axis and composite good Y on the vertical axis.
Draw the original budget line (BL1) and the consumer's optimal bundle (point A) where BL1 is tangent to indifference curve IC1.
Now increase the price of X. The budget line pivots inward around the Y-intercept (which does not change, since Y's price and income are constant). Draw the new budget line (BL2), which is steeper.
Find the new optimal bundle (point C) where BL2 is tangent to a lower indifference curve IC2. For a Giffen good, point C lies to the right of point A on the X-axis, meaning the consumer buys more X despite the price increase.
To decompose: draw a compensating budget line (BL*) parallel to BL2 (same slope, reflecting the new price ratio) but tangent to the original indifference curve IC1. The tangency point is B.
The substitution effect is the movement from A to B along IC1. B lies to the left of A on the X-axis (the consumer substitutes away from the now-more-expensive X). This is the standard direction.
The income effect is the movement from B to C. For a Giffen good, C lies to the right of B by more than A lies to the right of B. That is, the income effect (B to C, moving right) more than reverses the substitution effect (A to B, moving left).
The total effect (A to C) shows increased consumption of X: the hallmark of a Giffen good.
The Slutsky equation captures the decomposition algebraically:
\frac{\partial Q_X}{\partial P_X} = \underbrace{\frac{\partial Q_X}{\partial P_X}\bigg|_{U=\bar{U}}}_{\text{substitution effect}} - Q_X \cdot \underbrace{\frac{\partial Q_X}{\partial I}}_{\text{income effect direction}}For graphical work, the key labels on your diagram should be:
BL1: original budget line
BL2: new budget line after price increase of X (steeper, pivots around Y-intercept)
BL*: compensating budget line (parallel to BL2, tangent to IC1)
IC1: original indifference curve
IC2: new, lower indifference curve
A: original optimal bundle (on IC1 and BL1)
B: hypothetical bundle isolating the substitution effect (on IC1 and BL*)
C: new optimal bundle (on IC2 and BL2)
Substitution effect: A → B (X decreases)
Income effect: B → C (X increases, by more than the substitution effect reduced it)
Total effect: A → C (X increases)
The classic real-world example cited for Giffen behaviour is the consumption of rice among very poor households in Hunan and Gansu provinces in China, documented in a 2008 study by Jensen and Miller. When the price of rice was subsidised (effectively lowered), some households consumed less rice and more meat. When the subsidy was removed (price rose), they could no longer afford meat and had to eat more rice. The substitution-income decomposition is also used routinely in labour economics to analyse how wage changes affect the trade-off between work and leisure.
Students often think the substitution effect can go in either direction. It cannot. The substitution effect always moves demand away from the good whose price rose. For every good, including Giffen goods.
A frequent error is thinking all inferior goods are Giffen goods. They are not. Most inferior goods still have a downward-sloping demand curve because the substitution effect dominates. A Giffen good is the extreme special case.
Students sometimes draw the compensating budget line (BL*) parallel to the original budget line instead of the new one. BL* must be parallel to BL2 (reflecting the new price ratio) and tangent to the original indifference curve IC1.
Another mistake is placing point C to the left of point A when drawing a Giffen good diagram. For a Giffen good, C must be to the right of A on the X-axis, since the whole point is that total consumption of X increases.
⚠️ The graphical decomposition of a Giffen good price increase is a classic 15-point exam question. Practise drawing it until the labels (A, B, C, BL1, BL2, BL*, IC1, IC2) come automatically.
⚠️ You must clearly show that the substitution effect (A to B) reduces X consumption, while the income effect (B to C) increases it by more. Label both effects on the diagram.
⚠️ Remember the hierarchy: Giffen goods are a subset of inferior goods, which are a subset of all goods. Every Giffen good is inferior, but not every inferior good is Giffen.
⚠️ If the question asks you to choose between a numerical example and the general case, the general case is usually safer: it shows you understand the logic without risking arithmetic errors.
True or false: The substitution effect for a Giffen good works in the opposite direction to a normal good.
Fill in the blank: A Giffen good must be a(n) ____ good.
True or false: When the price of a Giffen good rises, the consumer buys less of it.
Fill in the blank: The compensating budget line BL* is parallel to the ____ budget line.
True or false: All inferior goods are Giffen goods.
Answers: 1. False (the substitution effect always works the same way). 2. Inferior. 3. False (the consumer buys more). 4. New (BL2). 5. False.
Q: Show graphically how to decompose the total effect of a price increase of a Giffen good X into substitution effect and income effect. Describe each step.
A: Draw axes with Giffen good X on the horizontal axis and composite good Y on the vertical axis. Start with budget line BL1 tangent to indifference curve IC1 at point A. Increase the price of X: the budget line pivots inward to BL2 (steeper, same Y-intercept). Find the new optimum C on IC2 (a lower indifference curve), noting that C is to the right of A on the X-axis (more X consumed). To decompose: draw BL* parallel to BL2 but tangent to IC1, touching at point B. The substitution effect is A to B (less X, standard direction). The income effect is B to C (more X, because X is inferior and the income effect dominates). The total effect A to C shows increased X consumption.
Q: Explain the difference between an inferior good and a Giffen good.
A: An inferior good is any good for which demand falls as income rises (negative income elasticity). A Giffen good is a special type of inferior good where the (negative) income effect of a price change is large enough to overwhelm the substitution effect. All Giffen goods are inferior, but the vast majority of inferior goods are not Giffen: for most inferior goods, the substitution effect still dominates, and the demand curve slopes downward normally.
Q: Can the substitution effect ever increase consumption of a good whose price has just risen?
A: No. The substitution effect always moves demand away from the good whose relative price increased. This holds for normal goods, inferior goods, and Giffen goods alike. Only the income effect can push consumption of a more-expensive good upward, and it does so only for inferior goods.
The substitution-income decomposition is the foundation for understanding labour supply curves (the backward-bending supply curve is essentially the same logic applied to work-leisure choices). It also connects to the theory of the firm: input demand functions can be decomposed into substitution and output effects in an analogous way. Understanding Giffen goods helps clarify the law of demand: the law holds for the vast majority of goods, and Giffen goods are the theoretical exception that proves the rule requires specific, restrictive conditions to fail.
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