Changes

The “substitution effect” is the change in substitution (one good for another) due to the change in price of one of the two goods.  If the price of a good decreases, then that price change makes it more attractive to be used as a substitute for another good.  If, for example, chicken sandwiches are on sale at half-price at McDonalds, then more customers are going to choose chicken sandwiches as a substitute for hamburgers.  The decrease in price of chicken sandwiches has a “substitution effect” of causing more people to buy them as they move from eating hamburgers to eating the cheaper chicken sandwiches.

The “substitution effect” is the change in substitution (one good for another) due to the change in price of one of the two goods.  If the price of a good decreases, then that price change makes it more attractive to be used as a substitute for another good.  If, for example, chicken sandwiches are on sale at half-price at McDonalds, then more customers are going to choose chicken sandwiches as a substitute for hamburgers.  The decrease in price of chicken sandwiches has a “substitution effect” of causing more people to buy them as they move from eating hamburgers to eating the cheaper chicken sandwiches.

== Bizarre Exceptions ==

== For Honors Students Only: Giffen Goods ==

Last class, we mentioned an odd type of good known as an “inferior” good.  You may recall that the demand for an “inferior” good actually increases when income decreases.  Examples are margarine (because people with declining income can less afford butter).  Bankruptcy services are “inferior”, because the greater the decline in income, the more people who file for bankruptcy, and the greater the demand for those services.  If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

'''''Question''''': If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

Ponder that question further.  From above, the overall change in quantity demanded is a sum of the “income effect” and the “substitution effect.”  The “income effect” when the price decreases is that real income goes up.  But for an “inferior” good, an increase in income means a decrease in demand!  That’s strange.  The price decreases, but the demand due to the income effect of that price decrease also decreases.

Think about it.  From the prior section, the overall change in quantity demanded is a sum of the “income effect” and the “substitution effect.”  Let's look at the income effect first.  Ordinarily, the “income effect” when the price decreases is that real income goes up.  But for an “inferior” good, an increase in income means a decrease in demand!  That’s strange.  Thus for an inferior good, when the price decreases, the income effect is a decrease in demand.

However, the “substitution effect” goes up when the price falls.  Because the income effect and substitution effect move in opposite directions, it is difficult to predict what will happen to their sum, which is the overall demand.  A “Giffen good” is an inferior good for which the income effect dominates, and thus it has the unusual characteristic that a fall in price of the good causes a fall in demand.  It is difficult to think of an example.   

However, the “substitution effect” goes up when the price falls, even for an inferior good.  Because the income effect and substitution effect move in opposite directions, it is difficult to predict what will happen to their sum, which is the overall demand.  A “Giffen good” is an inferior good for which the income effect dominates, and thus it has the unusual characteristic that a fall in price of the good causes a fall in demand.  A Giffen good violates the Law of Demand.  It is difficult to think of an example.   

It is worth defining a “Giffen good” again, this time in terms of a price increase: '''''A "Giffen good" is a good which has an increase in demand when its price increases'''''.  Raise the price of a Giffen good, and the demand for this good increases.  (All other goods have a decrease in demand when the price of the good increases.)   

It is worth defining a “Giffen good” again, this time in terms of a price increase: '''''A "Giffen good" is a good which has an increase in demand when its price increases'''''.  Raise the price of a Giffen good, and the demand for this good increases.  (All other goods have a decrease in demand when the price of the good increases.)   

Another textbook example of a “Giffen good” is the potato during the terrible Irish famine of 1846-1849.  This famine caused nearly a million Irish to die of starvation, and forced nearly another million to emigrate to the United States, Britain, Canada and Australia.  Economists say that the potato during the famine was Giffen good.  The potato crops failed and there was less supply of potatoes, which caused its price to increase.  But the poor Irish, after paying the higher price for potatoes, had less money left to buy more expensive foods.  So they had no choice but to buy even more potatoes to fill their stomachs!  In other words, the increase in the price of the potato wiped out the savings of the Irish, who then bought even more potatoes despite its increase in price.  Note that the potato could have been a Giffen good only if it was also an “inferior” good that saw a surge in demand when people had less income (less money to spend).

Another textbook example of a “Giffen good” is the potato during the terrible Irish famine of 1846-1849.  This famine caused nearly a million Irish to die of starvation, and forced nearly another million to emigrate to the United States, Britain, Canada and Australia.  Economists say that the potato during the famine was Giffen good.  The potato crops failed and there was less supply of potatoes, which caused its price to increase.  But the poor Irish, after paying the higher price for potatoes, had less money left to buy more expensive foods.  So they had no choice but to buy even more potatoes to fill their stomachs!  In other words, the increase in the price of the potato wiped out the savings of the Irish, who then bought even more potatoes despite its increase in price.  Note that the potato could have been a Giffen good only if it was also an “inferior” good that saw a surge in demand when people had less income (less money to spend).

Other economists suggest that tortillas are a Giffen good in Mexico today.  But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods. Rice and noodles are now described as Giffen goods among the poor in China.  Do you believe it?

Other economists suggest that tortillas are a Giffen good in Mexico today.  But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods.<ref>"There is no way to buy more potatoes when there are fewer potatoes. Thus, the Giffen legend concerning the great potato famine appears at best to be a misinterpretation of some observed but misunderstood phenomenon, and at worst a kind of hoax."

  Rice and noodles are now described as Giffen goods among the poor in China.  Do you believe it?

Giffen goods are exceptions to the Law of Demand ... if Giffen goods really exist!  Many, including your teacher, are skeptical that there really is such a thing as a Giffen good.

Giffen goods are exceptions to the Law of Demand ... if Giffen goods really exist!  Many, including your teacher, are skeptical that there really is such a thing as a Giffen good.

==Utility==

==Utility==