Behind the Demand Curve: Consumer Choice

Explaining the law of demand The Substitution effect ▫Remember the law of demand, this why the demand curve slopes downward ▫An alternative way to think about why demand curves slope downward is to focus on opportunity cost

▫The change in the quantity demanded as the good has become relatively cheaper is substituted for the good that was become relatively more expensive….this is known as the substitution effect  When a good absorbs only a small share of the typical consumer’s income, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward. ▫There are some goods i.e. food and housing, that account for a substantial share of many consumers’ incomes…..this brings in the income effect

The Income effect ▫Example: half of family income is spent on rental housing  Price of housing increases everywhere and will have a substitution effect on the family’s demand  All things being equal, the family will have an incentive to consume less housing  In a real sense the family will also be made poorer by that higher housing price ▫Income will by less housing than before

 When income is adjusted to reflect its true purchasing power it is called real income  In contrast money that has not been adjusted is called money income or nominal income

The income effect is the change in quantity of a good demanded that results from a change in the overall purchasing power of the consumer’s income due to a change in the price of that good.

Distinction between the two effects ▫For the majority of goods and services, the income effect is not important and has no significant effect on individual consumption  Market demand curves slope downward solely because of substitution effect ▫When it matters at all, income effect usually reinforces the substitution effect  Vast majority of goods are normal goods (goods for which demand decreases when income falls)  This reinforces the substitution effect

 With inferior goods- income effect and substitution effect work in opposite directions  Substitution effect decrease the quantity demanded as its price increases, the income effect of a price increase for an inferior good is an increase in quantity demanded  Price increase lowers real income, as real income falls demand for an inferior good increases

Defining and measuring elasticity ▫Economist use the concept of elasticity to measure the responsiveness of one variable to change in another ▫Price elasticity of demand  Measures the responsiveness of quantity of demand to changes in price ▫Calculating the price elasticity of demand

Calculate % change in demand ▫% change in quantity demand = change in quantity demanded/ initial quantity demanded X 100

Calculate % change in price ▫% change in price = change in price/ initial price X 100

Calculate price elasticity of demand Find ratio of the % change in Quantity demanded and in % change in price ▫Price elasticity of demand = %change in quantity demanded/ % change in price