Question

Discuss the substitution effect and the​ real-income effect of a price decrease.

Answer 1

The price effect ( combined with Substitution + Income effect) traces the effect of change in price on the demand.
Substitution effect: shows Change in demand due to change in relative price.
Income effect : shows change in demand due to change in real income due to change in price.
Substitution is always negative, while the direction of the income effect depends on the nature of good.
Let us take the example of three types of goods.
Normal Goods: Suppose price of the normal good decreases,
Substitution effect:NEGATIVE. As the price has decreased, the good becomes relatively cheaper compared to other goods, so its demand increases.
Income effect:POSITIVE. As prices falls, this increases the real income of the consumer as s/he has to spend less to buy same quantity. So its demand increases.
In the case of normal goods, substitution and income effects move in same direction. So when price falls, demand increases.

Inferior Goods: If price falls,
Substitution effect:NEGATIVE the price reduction makes the good cheaper relatively. Hence, demand increases.
Income effect:NEGATIVE (as price decreases, demand decreases) As the price falls, the real income increases. But due to the quality of it being inferior, the demand decreases because the consumer can consume the same good with less money. With the money left, s/he tends to increase their demand for normal goods.
Hence, substitution and income effects work in opposite direction. However, the demand curve still slopes downward because the relative strength of substitution effect is so strong that it outweighs the strength of income effect. So when price falls, demand increases of inferior goods.

Giffen Goods (special kind of inferior goods): Price falls,
Substitution effect: NEGATIVE. As price falls, the good becomes cheaper so its demand tends to increase.
Income effect: NEGATIVE.  As price falls, although the real income increases, but the demand decreases.
Although the substitution and income effects work in opposite direction but the strength of income effect becomes so strong that it outweigh substitution effect.
So when price falls, demand also falls and demand curve slopes upward.