Consumer Choice

Income Effect and Price Effect

1
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 sometimes
opposes each other
 No matter whether you use marginal utility approach or

Indifference Curve approach to derive the demand curve

2
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 opposite
direction to the price change
 When price decreases (increases), substitution effect

works to increase (decrease) quantity demanded

3
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 consumer’s purchasing power
increases, causing a change in quantity demanded for the good
 Income effect of a price change arises from a change in purchasing
power over both goods
 Income effect can work to either increase or decrease the
quantity of a good demanded, depending on whether the good
is normal or inferior

4
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)

5
Normal Goods
 Substitution and income effects work together
 Substitution effect: price of one goods rises, decreasing the
quantity demanded for this goods and equivalently leading
to 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

6
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

7
Income and Substitution Effects
Price Decrease: Ultimate
Effect
P Substitution Effect (Almost Always)
QD

 QD
Purchasing QD if normal
Power QD if inferior

Price Increase:

P Substitution Effect
QD

 QD
Purchasing QD if normal
Power
QD if inferior
8
Response to an income increase: both goods normal

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

U1

20 35
F 9
Income effects
C Normal; F inferior

C
100 Both F and C Normal

B
F Normal; C inferior

U1

20 35
F 10
Response to a price change: Price of food rises

Substitution effect:
effect A to B
C
100 Incentive to consume more of other
goods when the price of food rises
B
As price of food rises, substitute toward
Clothing and away from Food
A

U1

20
F 11
Response to a price change: Price of food rises

Income effect:
effect
C
100 As price of food rises, budget set shrinks
B “REAL” Income falls
Tend to reduce consumption of both
C goods if they are normal

U1

20
F 12
Response to a price change: Price of food rises

Income effect:
effect B to C
C
100 Can’t afford Point A anymore
B

C A

U1 Lost real
income
20
F 13
Response to a price change: Price of food rises
Total effect= Income effect + substitution
effect:
effect A to C
C Substitution effect: toward C, away from F
100
Income effect: away from C, away from F
B
Total effect = income effect + subst effect
C A

U1

20
F 14
Response to a price change: Price of food rises

Total effect= Income effect + substitution

effect:
effect A to C
C
100 Substitutes: Substitution effect dominates
the income effect so clothing demand rises
C1 when price of food rises
C A
C0

U1

20
F 15
Response to a price change: Price of food rises

Total effect= Income effect + substitution

C effect:
effect A to C
100
Complements: Income effect dominates
the substitution effect so clothing demand
falls when price of food rises
C A
C0
C’1
U1

20
F 16
Deriving an individual demand curve:
Let price of food rise
C
P F
5 14
10 7
15 4

F 17

4 7 14
Individual demand

15

10
Demand
5

4 7 14 F 18
Consumers in Markets
-- Aggregation of Demand 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

19
 From Individual To Market Demand
Jerry George Elaine
Price Price Price

$4 $4 $4

3 3 3

2
c + 2
C' + 2 C'' =
1 1 1

0 4 12 0 6 12 0 10 20
Number of Bottles per Week
20
Figure 8(b): From Individual To
Market Demand
Price
A
$4

B Market
3 Demand Curve

C
2

D
1

3 10 27 44
Number of Bottles per Week
21