2.3 Income/Price Changes & Income and Substitution effects 2.3.1Income Consumption Curves 2.3.2Price Consumption Curves 2.3.3Income and Substitution Effects 2.3.4Application with Different Types of Goods

Application “Household prices and the great affordability gap” The Times 5 th September 2007 House prices rising far faster than earnings In UK, three times faster Price of housing rising so proportion spent on it rises Similar patterns happening across developed economies

2.3.1 Income Consumption Curves If income changes, BC shifts in a parallel fashion (in or out) If Price changes, BC pivots (in or out) QB QA BC1 BC2BC3 Income Consumption Curve Curve shows preference for a good

An example: Engel Curves Food Spend Income As income rises, proportion spent on food declines

QB QA U1 U2 U3 A1 A2A3 (Or all other goods) BC1 BC2BC3 Price Consumption Curve Price Consumption Curves 0

Note that at A1:At A2: At A3: PA QA X X X A1 A2A3 Y/OBC1 Y/OBC2 Y/OBC3 PRICE DEMAND CURVE

Position of the demand curve depends on: 1. Income levels - higher Y is further right D curve is 2. Tastes - stronger these are, further right the D curve 3. Prices of other goods - substitutes and complements

In a demand relationship the quantity consumed changes with price but what does the quantity change actually consist of? Substitution Effect - substitute other goods for A as Price of A rises Income Effect - as price of A falls, real income rises and so spend more on all goods Income and Substitution Effects

Direction and size of effects varies with type of good Normal Good - as price falls, consumption rises - as income rises, consumption rises Inferior Good - as price falls, consumption rises - as income rises, consumption falls Giffen Good - as price falls, consumption falls - as income rises, consumption falls Application to Different Types of Goods

Other Goods QA U1 U2 BC2 BC Normal Good Subs: 1 to 3 or A to C (-ve) Income: 3 to 2 or C to B (+ve) Price effect: A to B or 1 to 2 A B C BC3

Other Goods QA U1 U2 BC2 BC1BC32 3 A B C Inferior Good Subs: 1 to 3 or A to C (-ve) Income: 3 to 2 or C to B (-ve) Price effect: A to B or 1 to 2 1

Other Goods QA U2 U1 BC2 BC1BC A B C Giffen Good Subs: 1 to 3 or A to C (-ve) Income: 3 to 2 or C to B (-ve) Price effect: A to B or 1 to 2

Other Goods Housing U1 BC2 BC1 U2 BC3 H1H2 Q1 Housing Market Revisited