Income Effect and Substitution Effect
The price of A is decreased and the quantity demanded by the consumer increases from A0 to A2. The total change can be separated into the sum of the substitution effect and the income effect. The change in the quantity demanded because of the substitution effect is A1-A0. The change in the quantity demanded because of the income effect is A2-A1. Because the good is a normal good, the income effect is positive. (b) The demand function of this consumer has a negative slope.
When the income effect is larger than the substitution effect and the good is a Giffen good, the demand function has a positive slope. When the decreases to P’A, the quantity demanded by the consumer decreases from A0 to A2. (b) The demand function has a positive slope. The substitution effect is A1-A0, and the income effect is A2-A1. The income effect is negative and overwhelms the substitution effect.
References
The Open University of Hong Kong (1998) 'Consumption' in EC301 Economic Analysis of Business and Public Policies, Hong Kong: OUHK.
Pashigian, P B (1998) Price theory and application, New York: Worth.