The substitution effect and income effect of a price increase for a giffen good.

# A

"1
sub

B B!
inc total

B1

"2 B2

x!

x1

x2

The price of x increases causing the budget line to shift from B1 to B2. The consumer changes his consumption from the bundle of x and y represented by point A to the bundle represented by point B. The movement from A to B represents the total effect of the price change. In the Giffen good case, even though the price has increased, consumption of x has gone up. The demand curve will be upward sloping. To separate the substitution effect from the total effect, first dra a ne budget line, B!. B! is parallel to B2 because it represents the higher price for x. It must be tangent to the original indifference curve "1. In the graph above this is point #. $oint # sho s us ho much x the consumer ould buy if the price of x ere increased and at the same time he as given more income so that he as no orse off than he as before the price ent up. The movement from A to # is the substitution effect. The income effect is hat is left hen the substitution effect %A to #& is subtracted from the total effect %A to B&, hich is B to # in the graph above. ' is an inferior good because hen then the budget line shifts from B! to B2 %income decreases&, consumption of ' increases from x! to x2. (hat ma)es this inferior good a Giffen good is that the si*e of the income effect is bigger than the si*e of the substitution effect.