Income and Substitution Effect

Marginal Utility and the Law of Demand Price of fried clams rises Price of fried clams rises Does it change the marginal utility that a consumer gets from an additional pound of clams? Does it change the marginal utility that a consumer gets from an additional pound of clams? No, but it reduces the marginal utility per dollar spent on fried clams. No, but it reduces the marginal utility per dollar spent on fried clams. The decrease in marginal utility per dollar spent on clams gives the consumer an incentive to consume fewer clams when the price of clams rises The decrease in marginal utility per dollar spent on clams gives the consumer an incentive to consume fewer clams when the price of clams rises

Marginal Utility and the Law of Demand Explanation: The optimal consumption rule Explanation: The optimal consumption rule A utility-maximizing consumer chooses a consumption bundle for which the marginal utility per dollar spent on all goods is the same. A utility-maximizing consumer chooses a consumption bundle for which the marginal utility per dollar spent on all goods is the same. If marginal utility per dollar on clams falls because the price of clams rises, the consumer can increase his or her utility by purchasing fewer clams and more of other goods If marginal utility per dollar on clams falls because the price of clams rises, the consumer can increase his or her utility by purchasing fewer clams and more of other goods

Marginal Utility and the Law of Demand If the price of clams falls, the opposite happens If the price of clams falls, the opposite happens The marginal utility per dollar spent on clams increases at any given level of clam consumption The marginal utility per dollar spent on clams increases at any given level of clam consumption A consumer can increase his or her utility by purchasing more clams and less of other goods when the price of clams falls A consumer can increase his or her utility by purchasing more clams and less of other goods when the price of clams falls

Marginal Utility and the Law of Demand When the price of a good increases, an individual will normally consume less of that good and more of other goods When the price of a good increases, an individual will normally consume less of that good and more of other goods When the price of a good decreases, an individual will normally consume more of that good and less of other goods When the price of a good decreases, an individual will normally consume more of that good and less of other goods

Marginal Utility and the Law of Demand Consuming less when price increases and more when price decreases explains why the individual demand slopes downward Consuming less when price increases and more when price decreases explains why the individual demand slopes downward – The law of demand If individual demand curve slopes downward, the market demand curve will slope downward If individual demand curve slopes downward, the market demand curve will slope downward Demand curves sloping downward also show opportunity costs of goods and services Demand curves sloping downward also show opportunity costs of goods and services

Substitution Effect and the Law of Demand The effect of a price change on the quantity consumed is always present The effect of a price change on the quantity consumed is always present The substitution effect is the change in the quantity consumed as the consumer substitutes the good that has become relatively cheaper in place of the good that has become relatively more expensive The substitution effect is the change in the quantity consumed as the consumer substitutes the good that has become relatively cheaper in place of the good that has become relatively more expensive

Substitution Effect and the Law of Demand If the good absorbs only a small share of the consumer’s spending, the substitution effect is essentially the complete explanation of why the individual demand curve of that consumer slopes downward If the good absorbs only a small share of the consumer’s spending, the substitution effect is essentially the complete explanation of why the individual demand curve of that consumer slopes downward And, when a good absorbs only a small share of the typical consumer’s spending, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward And, when a good absorbs only a small share of the typical consumer’s spending, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward

Substitution Effect and the Law of Demand Exceptions are found Exceptions are found I.e. Housing Market I.e. Housing Market Goods like housing absorb a large share of a typical consumer’s spending Goods like housing absorb a large share of a typical consumer’s spending This makes the individual demand curve and the market demand curve become more complicated This makes the individual demand curve and the market demand curve become more complicated

The Income Effect As said, for the majority of goods, the substitution effect is sole reason behind the individual and market demand curves As said, for the majority of goods, the substitution effect is sole reason behind the individual and market demand curves Food and housing are exceptions due to the amount consumers have to spend Food and housing are exceptions due to the amount consumers have to spend

The Income Effect Example: Example: A family spends half its income on rental housing A family spends half its income on rental housing Housing prices increase everywhere Housing prices increase everywhere This will have a substitution effect (other things equal) the family will have an incentive to consume less housing and more of other goods This will have a substitution effect (other things equal) the family will have an incentive to consume less housing and more of other goods

The Income Effect The family though will be made poorer by the higher housing price – its income will buy less housing than before The family though will be made poorer by the higher housing price – its income will buy less housing than before The amount of income adjusted to reflect its true purchasing power is termed “real income” The amount of income adjusted to reflect its true purchasing power is termed “real income” The reduction in the consumer’s real income will have an additional effect on the family’s consumption bundle, including its consumption of housing The reduction in the consumer’s real income will have an additional effect on the family’s consumption bundle, including its consumption of housing

The Income Effect The income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer’s purchasing power due to the change in the price of that good The income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer’s purchasing power due to the change in the price of that good In this example, a change in the price of a good effectively changes a consumer’s income because it alters the consumer’s purchasing power In this example, a change in the price of a good effectively changes a consumer’s income because it alters the consumer’s purchasing power

The Income Effect The distinction between substitution effect and income effect: The distinction between substitution effect and income effect: 1.For the majority of goods and services, the income effect is not important and has no significant effect on individual consumption. The market demand curve slope downward solely because of the substitution effect

The Income Effect 2.When it matters at all, the income effect usually reinforces the substitution effect. The price of a good that absorbs a substantial share of income rises, consumers of that good become a bit poorer because their purchasing power falls. The vast majority of goods are normal goods, goods for which demand decreases when income falls The vast majority of goods are normal goods, goods for which demand decreases when income falls

The Income Effect For an inferior good, a good for which demand increases when income falls, the income and substitution effect work in opposite directions For an inferior good, a good for which demand increases when income falls, the income and substitution effect work in opposite directions The substitution effect tends to produce a decrease in the quantity of any good demanded as its price increases but for an inferior good, the income effect of a price increases tends to produce an increase in the quantity demanded The substitution effect tends to produce a decrease in the quantity of any good demanded as its price increases but for an inferior good, the income effect of a price increases tends to produce an increase in the quantity demanded

The Income Effect As a result of all of this, there a hypothetical cases involving inferior goods in which distinction between income and substitution effects are important As a result of all of this, there a hypothetical cases involving inferior goods in which distinction between income and substitution effects are important Typically, income effects are important only for a limited number of goods Typically, income effects are important only for a limited number of goods

Income and Substitution Effect Notes

Marginal Utility and the Law of Demand Price of fried clams rises Price of fried clams rises Does it change the marginal utility that a consumer gets from an additional pound of clams? Does it change the marginal utility that a consumer gets from an additional pound of clams? The decrease in marginal utility per dollar spent on clams gives the consumer an incentive to consume fewer clams when the price of clams rises The decrease in marginal utility per dollar spent on clams gives the consumer an incentive to consume fewer clams when the price of clams rises

Marginal Utility and the Law of Demand Explanation: The optimal consumption rule Explanation: The optimal consumption rule If marginal utility per dollar on clams falls because the price of clams rises, the consumer can increase his or her utility by purchasing fewer clams and more of other goods If marginal utility per dollar on clams falls because the price of clams rises, the consumer can increase his or her utility by purchasing fewer clams and more of other goods

Marginal Utility and the Law of Demand If the price of clams falls, the opposite happens If the price of clams falls, the opposite happens A consumer can increase his or her utility by purchasing more clams and less of other goods when the price of clams falls A consumer can increase his or her utility by purchasing more clams and less of other goods when the price of clams falls

Marginal Utility and the Law of Demand

Consuming less when price increases and more when price decreases explains why the individual demand slopes ______________ Consuming less when price increases and more when price decreases explains why the individual demand slopes ______________ If individual demand curve slopes downward, the market demand curve will slope _______________ If individual demand curve slopes downward, the market demand curve will slope _______________ Demand curves sloping downward also show __________________of goods and services Demand curves sloping downward also show __________________of goods and services

Substitution Effect and the Law of Demand The effect of a price change on the quantity consumed is always present The effect of a price change on the quantity consumed is always present

Substitution Effect and the Law of Demand If the good absorbs only a small share of the consumer’s spending, the substitution effect is essentially the complete explanation of why the individual demand curve of that consumer slopes downward If the good absorbs only a small share of the consumer’s spending, the substitution effect is essentially the complete explanation of why the individual demand curve of that consumer slopes downward And, when a good absorbs only a small share of the typical consumer’s spending, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward And, when a good absorbs only a small share of the typical consumer’s spending, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward

Substitution Effect and the Law of Demand Exceptions are found Exceptions are found Goods like ______________ absorb a large share of a typical consumer’s spending Goods like ______________ absorb a large share of a typical consumer’s spending This makes the individual demand curve and the market demand curve become more complicated This makes the individual demand curve and the market demand curve become more complicated

The Income Effect As said, for the majority of goods, the substitution effect is sole reason behind the individual and market demand curves As said, for the majority of goods, the substitution effect is sole reason behind the individual and market demand curves ___________________are exceptions due to the amount consumers have to spend ___________________are exceptions due to the amount consumers have to spend

The Income Effect Example: Example: This will have a ______________ effect (other things equal) the family will have an incentive to consume less housing and more of other goods This will have a ______________ effect (other things equal) the family will have an incentive to consume less housing and more of other goods

The Income Effect The family though will be made poorer by the higher housing price – its income will buy less housing than before The family though will be made poorer by the higher housing price – its income will buy less housing than before The amount of income adjusted to reflect its true purchasing power is termed “real income” The amount of income adjusted to reflect its true purchasing power is termed “real income” The reduction in the consumer’s real income will have an additional effect on the family’s consumption bundle, including its consumption of housing The reduction in the consumer’s real income will have an additional effect on the family’s consumption bundle, including its consumption of housing

The Income Effect The income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer’s purchasing power due to the change in the price of that good The income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer’s purchasing power due to the change in the price of that good In this example, a change in the price of a good effectively changes a consumer’s income because it alters the consumer’s purchasing power In this example, a change in the price of a good effectively changes a consumer’s income because it alters the consumer’s purchasing power

The Income Effect The distinction between substitution effect and income effect: The distinction between substitution effect and income effect:1.

The Income Effect 2. The vast majority of goods are normal goods, goods for which demand decreases when income falls The vast majority of goods are normal goods, goods for which demand decreases when income falls

The Income Effect For an inferior good, For an inferior good, The substitution effect tends to produce a _____________ in the quantity of any good demanded as its price ____________ but for an inferior good, the income effect of a price increases tends to produce an ___________ in the quantity _______________ The substitution effect tends to produce a _____________ in the quantity of any good demanded as its price ____________ but for an inferior good, the income effect of a price increases tends to produce an ___________ in the quantity _______________

The Income Effect As a result of all of this, there a hypothetical cases involving inferior goods in which distinction between income and substitution effects are important As a result of all of this, there a hypothetical cases involving inferior goods in which distinction between income and substitution effects are important Typically, income effects are important only for a limited number of goods Typically, income effects are important only for a limited number of goods