1. AP Economics Mr. Bernstein Module 46 (pp 457-460 only): Income and Substitution Effects October 6, 2014

2. AP Economics Mr. Bernstein Law of Demand All other things equal, as price increases the quantity demanded falls So there is an inverse relationship between price and quantity demanded Plotted on a graph, the law of demand infers a downward sloping demand curve Why? 2

3. AP Economics Mr. Bernstein The Substitution Effect The downward sloping demand curve and opportunity costs Costs: Driving into city = $20; bus ticket = $10 The opportunity cost of driving = 2 bus tickets If the price of bus tickets rise to $15, the opportunity cost of driving a car decreases to 1.33 bus tickets Driving becomes relatively cheaper and the quantity demanded rises 3

4. AP Economics Mr. Bernstein The Substitution Effect The downward sloping demand curve and opportunity costs Costs: Driving into city = $20; bus ticket = $10 The opportunity cost of driving = 2 bus tickets If the price of bus tickets falls to $5, the opportunity cost of driving a car increases to 4 bus tickets Driving becomes relatively more expensive and the quantity demanded falls 4

5. AP Economics Mr. Bernstein Note on the Substitution Effect Substitution Effect causes change in Quantity Demanded for product (i.e., Q D decreases as consumers shift to cheaper product It also causes shift in Demand for substitute product (i.e., D sub increases) 5

6. AP Economics Mr. Bernstein The Income Effect Changes in real income Primarily effects major purchases New job, higher income = nicer car Lose job, lose income = less nice car Income not keeping up with inflation = lower real income = less nice car Reinforces Substitution Effects Causes Demand Curve to slope downward 6