1 Impact of Change in Income Here we want to consider the change consumers will make if they experience a change in income.

2 change in income. Note that the budget line is a summary of the baskets of goods that a consumer can buy. The consumer ultimately picks the basket that is able to be purchased and gives the individual the most satisfaction or happiness. For the next few slides let’s just think about the budget line and not about consumer utility maximization.

3 change in income - budget change y x Remember on the budget line we are measuring the amount of x and y the consumer can buy given their income and given the fact that prices must be paid. x1 y1 I have illustrated one basket the consumer can buy. With the price of x = Px and the price of y = Py the consumer here could buy x1, y1.

4 change in income - budget change y x There are many ways to think about how the budget line would change given an income change, but one way to think about it would be to pick a given amount of x, say x1. Before the income x1 y1 change say that once x1 is bought that leaves only y1 of y. Now if there is an income increase, after x1 is bought that would leave more money to spend on y and thus y2 could be bought (I just say could – it may not be bought). y2

5 change in income - budget change From the previous screen we can see more y can be bought if there is more income available, but how much more depends on the prices of x and y and it depends on the income change. But, as income rises more y can be bought, given an amount of x is bought. Thus the budget line shifts out in a parallel fashion if income grows and by a similar logic shifts in parallel if there is an income decline.

6 change in income - optimal point change Now that we know how the budget changes given an income change, let’s see how the consumer optimum changes(given that taste and preferences do not change).

7 change in income - optimal point change y x Say the consumer starts out at point a - x1, y1 gives maximum satisfaction. Note I have extended a line above point x1. Now with more income the budget line shifts out. The consumer will end up either x1 y1 to the right or the left of the dashed line. If the consumer ends up to the right, more x is wanted with more income. If the consumer ends up to the left of the dashed line then less x is wanted when more income is obtained. a

8 change in income - optimal point change A normal good is one where that as the consumer gets more income more of the product is demanded (or less income means less of the good is demanded). An inferior good is one where as the consumer gets more income less of the product is demanded (or less income means more of the good is demanded).

9 change in income - optimal point change y x It just so happens here that when income went up the consumer moves to a point where there is more x than before. This is the case of a normal good. x1 y1 a

10 change in income - optimal point change y x It just so happens here that when income went up the consumer moves to a point where there is less x than before. This is the case of an inferior good. x1 y1 a Example: When you think of music CD’s are probably normal and cassettes are probably inferior. In general we are not sure if goods are normal or inferior until we do a study. Here we show what happens in each case.

11 Income consumption path y x x1 x2 y1 When we look at several consumer optimum points at various levels of income and then trace out the points with a line we get the income consumption path. Here both goods are normal goods. Would the income consumption path be downward sloping if only one of the goods were inferior? a

12 Engel curve - normal good y x x1 x2 y1 In the right hand picture we can see an income increase and from the left graph we take the new x, x2, and draw it in with the new income level. The Engel curve for a normal good is upward sloping. What about for an inferior good? a x x x2 x1 I1 I2 This is the Engel curve