Explain the income and substitution effects of a fall in price and distinguish between normal, inferior and Giffen goods.

1. 1 · Introduce the price effect. A price fall changes relative prices and real income at the same time.
2. 2 · Define the two effects. Substitution effect: due to relative prices, real income constant. Income effect: due to changed purchasing power.
3. 3 · Draw the Hicks decomposition. [Diagram: original budget line and IC1 at E1; new pivoted line and IC2 at E2; a compensating line parallel to the new line tangent to IC1 at E3; E1 → E3 substitution effect, E3 → E2 income effect]
4. 4 · Work a numerical case. Px 100 → 50: X 10 → 20; compensated income Rs. 1,500 gives X = 15; SE +5, IE +5.
5. 5 · Compare types of goods.
   • Normal: both effects increase quantity
   • Inferior: income effect negative but smaller
   • Giffen: negative income effect larger, so quantity falls
6. 6 · Link to the demand curve. The PCC traced by price changes gives the demand curve; it slopes down except for Giffen goods.
7. 7 · Sri Lankan business link. Price cuts on branded goods in supermarkets win buyers mostly through the substitution effect.
8. 8 · Conclude. Separating the two effects explains why demand curves normally slope down and when they may not.

Scoring tip: Label E1, E2 and E3 and write SE and IE under the X axis with arrows. That one diagram earns most of the marks.