Economics Winter 14 March 3 rd, 2014 Lecture 18 Ch. 9 Ordinal Utility: Indifference Curve Analysis

The Effect of Price Change A fall in the price of a good has two effects: 1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive (rationale for substitution effect) 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power (real income effect as nominal income is kept unchanged)

INCOME AND SUBSTITUTION EFFECTS Substitution effect Change in consumption of a good associated with a change in its price, with the level of utility held constant. Income effect Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant.

The Substitution Effect of Price Change –The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve. –When the relative price falls, the consumer always substitutes more of that good for other goods. –The substitution effect is the first reason why the demand curve slopes downward.

The total effect of a change in price is given theoretically by the sum of the substitution effect and the income effect

Quantity of Y per week Y* Quantity of X per week X*0 Income and Substitution Effects of a Fall in Price U1U1 A

Quantity of Y per week Y* Old budget constraint B Substitution effect New budget constraint Quantity of X per week X*XBXB 0 Income and Substitution Effects of a Fall in Price U1U1 A

Quantity of Y per week Y** Y* Old budget constraint B Substitution effect Income effect Total increase in X New budget constraint Quantity of X per week X*XBXB X**0 Income and Substitution Effects of a Fall in Price U1U1 U2U2 A C

Substitution Effect and Income Effect

Figure Substitution and Income Effects with Normal Goods Wine, Gallons per year Substitution effect Total effect Income effect Beer, Gallons per year I 2 I 1 L* L 2 L 1 e 2 e 1 e*

Income and substitution effects: sign of an effect Effect is negative, if price and quantity move in opposite directions; Effect is positive, if price and quantity move in the same direction

Income and substitution effect with an inferior good: substitution effect: opposite of price movement income effect: same direction as price movement

U1U1 U2U2 E F G Good Y Good X Is good X inferior or normal? Substitution effect Income effect

A Giffen Good