8 Income Effect

8/8/2019 8 Income Effect

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Consumer Choice

Income Effect and Price Effect


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Income Effect And Price Effect Demand curve actually summarizes impact of

two separate effects of price change on

quantity demanded Substitution effects

Income effects

Effects sometimes work together, and sometimesopposes each other

No matter whether you use marginal utility approach or

Indifference Curve approach to derive the demand curve


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Substitution Effects Substitution effects

As the price of a good falls, the consumer substitutes that

good in place of other goods whose prices have not

changed

Substitution effect of a price change arises from a

change in the relative price of a good

And it always moves quantity demanded in the oppositedirection to the price change

When price decreases (increases), substitution effect

works to increase (decrease) quantity demanded


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The Income Effect A price cut gives consumer a gift, which is rather like an

increase in income

Income effect

As price of a good decreases, the consumerspurchasing powerincreases, causing a change in quantity demanded for the good

Income effect of a price change arises from a change in purchasingpower over both goods

Income effect can work to either increase or decrease the

quantity of a good demanded, depending on whether the goodis normal or inferior


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Combining Substitution and Income Effect

A change in the price of a good changes

Relative price of the good (the substitution effect)

and Overall purchasing power of the consumer (the

income effect)


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Normal Goods Substitution and income effects work together

Substitution effect: price of one goods rises, decreasing the

quantity demanded for this goods and equivalently leadingto decreased income, further decreasing consumption of the

other goods

Causing quantity demanded to move in opposite

direction of price Normal goods must always obey law of demand


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Inferior Goods Substitution and income effects of a price change work

against each other

Substitution effect moves quantity demanded in the opposite

direction of the price

While income effect moves it in same direction of price

But since substitution effect virtually always dominates

Consumption of inferior goods will virtually always obey law of

demand


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Income and Substitution EffectsPrice Decrease:

P

PurchasingPower

QD

QDQD

if normalif inferior

Substitution Effect

UltimateEffect

(Almost Always)

QD

Price Increase:

P QD

QD

QD

if normal

if inferior

Substitution Effect

QDPurchasing

Power


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Response to an income increase: both goods normal

C

F

100

20

U1

B

(PF / PC) = (MUF / MUC)at new income level

35


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Income effects

C

F

100

20

U1

B

35

F Normal; C inferior

C Normal; F inferior

Both F and C Normal


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Response to a price change: Price of food rises

C

F

100

20

U1

Substitution effectSubstitution effect: A to B

Incentive to consume more of other

goods when the price of food rises

As price of food rises, substitute toward

Clothing and away from FoodA

B


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C

F

100

20

U1

Income effectIncome effect:

As price of food rises, budget set shrinks

REAL Income falls

Tend to reduce consumption of both

goods if they are normalC

B


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C

F

100

20

U1

Income effectIncome effect: B to C

Cant afford Point A anymore

C A

Lost real

income

B


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C

F

100

20

U1

Total effect= Income effect + substitutionTotal effect= Income effect + substitution

effecteffect: A to C

Substitution effect: toward C, away from F

Income effect: away from C, away from F

Total effect = income effect + subst effect

C A

B


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C

F

100

20

U1



Substitutes: Substitution effect dominatesthe income effect so clothing demand rises

when price of food rises

C AC0

C1


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C

F

100

20

U1



Complements: Income effect dominates thesubstitution effect so clothing demand falls

when price of food risesC A

C0

C1


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Deriving an individual demand curve:

Let price of food rise

F

C

P F

5 14

10 7

15 4

4 7 14


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Individual demand

F4 7 14

15

10

5

Demand


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Consumers in Markets

-- Aggregation ofDemand Curve

Since market demand curve tells us

quantity of a good demanded by all

consumers in a market

Can derive it by summing individual

demand curves of every consumer in that

market


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From Individual To Market Demand

Number of Bottles per Week

c

4 12

JerryPrice

$4

0

3

2

1

C'

GeorgePrice

0 6 12

$4

3

2

1

C''

ElainePrice

0 10 20

$4

3

2

1

+ + =


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Figure 8(b): From Individual To

Market Demand

A

C

B

D

E

Market Demand

Curve

Price

$4

3

2

1

3 10 27 44

Number of Bottles per Week

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8 Income Effect