Substitution and Income Effect of a Price Increase for a Giffen Good
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 draw a new budget line, B3. B3 is parallel to B2 because it represents the higher price for x. It must be tangent to the original indifference curve U1. In the graph above this is point C. Point C shows us how much x the consumer would buy if the price of x were increased and at the same time he was given more income so that he was no worse off than he was before the price went up. The movement from A to C is the substitution effect. The income effect is what is left when the substitution effect (A to C) is subtracted from the total effect (A to B), which is B to C in the graph above. X is an inferior good because when then the budget line shifts from B3 to B2 (income decreases), consumption of X increases from x3 to x2. What makes this inferior good a Giffen good is that the size of the income effect is bigger than the size of the substitution effect. B1 B2 B3 A B C sub inc total x3 x1 x2 U1 U2