1. 1 Impact of Change in Price Here we want to see how the consumer optimum changes given a change in the price of a good.

2. 2 An example Say you buy 3 bottles of pop a week. Then the price of the pop decreases. If you still buy the 3 bottles of pop then you have money left in your pocket compared to before the price decrease. The price decrease has an effect just like an income increase. Thus we will talk about an “income effect” of a price change. But as the price declines we also think there are other products we won’t buy because we will now substitute the now cheaper pop. Maybe you would also have coffee, but with lower pop prices you substitute pop for coffee. Thus we will talk about a “substitution effect” of a price change. In economics, when the price of a product changes we think the quantity demanded changes because of both the income and substitution effects.

3. 3 change in price - budget change Now we want to focus on a price change. Let’s let the price of x change and see how the budget would shift or move. The way to think about this is to imagine spending all income on x. If the price of x rises, less can be spent on x and if the price of x falls more x can be purchased. Since the price of y was not able to change here, the maximum amount of y that could be bought should not change. Thus the budget line rotates with the center at the point on the y axis. The budget rotates clockwise for a price of x increase and counterclockwise for a price of x decline.

4. 4 change in price - budget change y x price increase decrease

5. 5 change in price - optimal point change y x x1 y1 Say the consumer starts out at x1, y1. If the price of x should fall the budget line rotates out in a counterclockwise fashion. The dashed line above x1 is similar to the one in the income change diagram. Except here we do not think the consumer will end up to the left of the dashed line when there is a price decline.

6. 6 change in price - optimal point change The reason we feel the consumer will not end up to the left of the dashed line is twofold: when the price falls 1) at the initial amount of x purchased the consumer feels richer and we saw this may make them buy more or less of x(income effect of a price change), 2) x becomes relatively cheaper and we feel people move toward now relatively cheaper products and away from now relatively more expensive items(substitution effect of a price change).

7. 7 change in price - optimal point change So, the income effect means more or less x given a price decline, and the substitution effect means more x given a price decline. Now if the good is an inferior good 1) the income effect says less x 2) the substitution effect says more x. The only way we could end up to the left of the dashed line on the previous screen is if the income effect operating with an inferior good is larger than the substitution effect. Economists have felt this rarely, if ever, happens.

8. 8 Price of X falls IncomeeffectIncomeeffect Normal inferior Substitution effect + + - + + + when sub>inc - when sub < inc

9. 9 income and substitution effect y x r s t Focusing only on good x here, say we start at point r. With a price decline in x this consumer would end up at point t. But I have also shown point s. Here is how to think about this point: after the price fall think about the consumer losing enough income so that the initial utility level could be obtained.

10. 10 income and substitution effect The movement from r to s highlights the substitution effect because the consumer had the income effect of the price change taken away. The movement from s to t is the income effect.

11. 11 The demand curve P x (usually we put Q) P1 P2 Q1 Q2 (r t) From 2 screens ago we saw a price decline had us move from point r to t. When we put this info into a price, quantity graph we see the demand curve is downward sloping.

12. 12 The demand curve You and I already knew the demand curve was downward sloping, but now we also know it is because we think substitution effects outweigh income effects. Plus we know at each point along the demand curve the consumer is maximizing their utility given the situation they find themselves in (like the price of x, the price of y and how much income they have.) We also know now that at lower prices the consumer reaches a higher level of satisfaction. This was not always obvious along just the demand curve.