Income and Substitution Effect. Marginal Utility and the Law of Demand Price of fried clams rises Price of fried clams rises Does it change the marginal.

Income Income and and

Substitution Substitution EffectEffect

Marginal Utility and the Law of Marginal Utility and the Law of DemandDemand

• Price of fried clams risesPrice of fried clams rises• Does it change the marginal utility that a Does it change the marginal utility that a

consumer gets from an additional pound of consumer gets from an additional pound of clams?clams?

• No, but it reduces the marginal utility per No, but it reduces the marginal utility per dollar spent on fried clams.dollar spent on fried clams.

• The decrease in marginal utility per dollar The decrease in marginal utility per dollar spent on clams gives the consumer an spent on clams gives the consumer an incentive to consume fewer clams when the incentive to consume fewer clams when the price of clams risesprice of clams rises


• Explanation: The optimal consumption ruleExplanation: The optimal consumption rule• A utility-maximizing consumer chooses a A utility-maximizing consumer chooses a

consumption bundle for which the marginal consumption bundle for which the marginal utility per dollar spent on all goods is the utility per dollar spent on all goods is the same.same.

• If marginal utility per dollar on clams falls If marginal utility per dollar on clams falls because the price of clams rises, the because the price of clams rises, the consumer can increase his or her utility by consumer can increase his or her utility by purchasing fewer clams and more of other purchasing fewer clams and more of other goodsgoods


• If the price of clams falls, the opposite If the price of clams falls, the opposite happenshappens

• The marginal utility per dollar spent on clams The marginal utility per dollar spent on clams increases at any given level of clam increases at any given level of clam consumptionconsumption

• A consumer can increase his or her utility by A consumer can increase his or her utility by purchasing more clams and less of other purchasing more clams and less of other goods when the price of clams fallsgoods when the price of clams falls


• When the price of a good increases, an When the price of a good increases, an individual will normally consume less of individual will normally consume less of that good and more of other goodsthat good and more of other goods

• When the price of a good decreases, an When the price of a good decreases, an individual will normally consume more individual will normally consume more of that good and less of other goodsof that good and less of other goods


• Consuming less when price increases and Consuming less when price increases and more when price decreases explains why the more when price decreases explains why the individual demand slopes downwardindividual demand slopes downward– The law of demandThe law of demand

• If individual demand curve slopes downward, If individual demand curve slopes downward, the market demand curve will slope the market demand curve will slope downwarddownward

• Demand curves sloping downward also show Demand curves sloping downward also show opportunity costs of goods and servicesopportunity costs of goods and services

Substitution Effect and the Law of Substitution Effect and the Law of DemandDemand

• The effect of a price change on the The effect of a price change on the quantity consumed is always presentquantity consumed is always present

• The substitution effect is the change in The substitution effect is the change in the quantity consumed as the consumer the quantity consumed as the consumer substitutes the good that has become substitutes the good that has become relatively cheaper in place of the good relatively cheaper in place of the good that has become relatively more that has become relatively more expensiveexpensive


• If the good absorbs only a small share of the If the good absorbs only a small share of the consumer’s spending, the substitution effect consumer’s spending, the substitution effect is essentially the complete explanation of is essentially the complete explanation of why the individual demand curve of that why the individual demand curve of that consumer slopes downwardconsumer slopes downward

• And, when a good absorbs only a small share And, when a good absorbs only a small share of the typical consumer’s spending, the of the typical consumer’s spending, the substitution effect is essentially the sole substitution effect is essentially the sole explanation of why the market demand explanation of why the market demand curve slopes downwardcurve slopes downward


• Exceptions are foundExceptions are found• I.e. Housing MarketI.e. Housing Market• Goods like housing absorb a large share Goods like housing absorb a large share

of a typical consumer’s spendingof a typical consumer’s spending• This makes the individual demand curve This makes the individual demand curve

and the market demand curve become and the market demand curve become more complicatedmore complicated

The Income EffectThe Income Effect

• As said, for the majority of goods, the As said, for the majority of goods, the substitution effect is sole reason behind substitution effect is sole reason behind the individual and market demand the individual and market demand curvescurves

• Food and housing are exceptions due to Food and housing are exceptions due to the amount consumers have to spendthe amount consumers have to spend


• Example:Example:• A family spends half its income on rental A family spends half its income on rental

housinghousing• Housing prices increase everywhereHousing prices increase everywhere• This will have a substitution effect (other This will have a substitution effect (other

things equal) the family will have an things equal) the family will have an incentive to consume less housing and incentive to consume less housing and more of other goodsmore of other goods

The Income EffectThe Income Effect• The family though will be made poorer by The family though will be made poorer by

the higher housing price – its income will buy the higher housing price – its income will buy less housing than beforeless housing than before

• The amount of income adjusted to reflect its The amount of income adjusted to reflect its true purchasing power is termed “real true purchasing power is termed “real income”income”

• The reduction in the consumer’s real income The reduction in the consumer’s real income will have an additional effect on the family’s will have an additional effect on the family’s consumption bundle, including its consumption bundle, including its consumption of housingconsumption of housing


• The income effect of a change in the price of The income effect of a change in the price of a good is the change in the quantity of that a good is the change in the quantity of that good consumed that results from a change in good consumed that results from a change in the consumer’s purchasing power due to the the consumer’s purchasing power due to the change in the price of that goodchange in the price of that good

• In this example, a change in the price of a In this example, a change in the price of a good effectively changes a consumer’s good effectively changes a consumer’s income because it alters the consumer’s income because it alters the consumer’s purchasing powerpurchasing power


• The distinction between substitution The distinction between substitution effect and income effect:effect and income effect:

1.1.For the majority of goods and services, the For the majority of goods and services, the income effect is not important and has no income effect is not important and has no significant effect on individual significant effect on individual consumption. The market demand curve consumption. The market demand curve slope downward solely because of the slope downward solely because of the substitution effectsubstitution effect


2.2. When it matters at all, the income effect When it matters at all, the income effect usually reinforces the substitution effect. usually reinforces the substitution effect. The price of a good that absorbs a The price of a good that absorbs a substantial share of income rises, substantial share of income rises, consumers of that good become a bit poorer consumers of that good become a bit poorer because their purchasing power falls.because their purchasing power falls.

• The vast majority of goods are normal The vast majority of goods are normal goods, goods for which demand decreases goods, goods for which demand decreases when income fallswhen income falls


• For an inferior good, a good for which For an inferior good, a good for which demand increases when income falls, the demand increases when income falls, the income and substitution effect work in income and substitution effect work in opposite directionsopposite directions

• The substitution effect tends to produce a The substitution effect tends to produce a decrease in the quantity of any good decrease in the quantity of any good demanded as its price increases but for an demanded as its price increases but for an inferior good, the income effect of a price inferior good, the income effect of a price increases tends to produce an increase in the increases tends to produce an increase in the quantity demandedquantity demanded


• As a result of all of this, there a As a result of all of this, there a hypothetical cases involving inferior hypothetical cases involving inferior goods in which distinction between goods in which distinction between income and substitution effects are income and substitution effects are importantimportant

• Typically, income effects are important Typically, income effects are important only for a limited number of goodsonly for a limited number of goods

Income Income and and

Substitution Substitution EffectEffectNotesNotes


• Price of fried clams risesPrice of fried clams rises• Does it change the marginal utility that a Does it change the marginal utility that a

consumer gets from an additional pound of consumer gets from an additional pound of clams?clams?

• The decrease in marginal utility per dollar The decrease in marginal utility per dollar spent on clams gives the consumer an spent on clams gives the consumer an incentive to consume fewer clams when the incentive to consume fewer clams when the price of clams risesprice of clams rises


• Explanation: The optimal consumption ruleExplanation: The optimal consumption rule

• If marginal utility per dollar on clams falls If marginal utility per dollar on clams falls because the price of clams rises, the because the price of clams rises, the consumer can increase his or her utility by consumer can increase his or her utility by purchasing fewer clams and more of other purchasing fewer clams and more of other goodsgoods


• If the price of clams falls, the opposite If the price of clams falls, the opposite happenshappens

• A consumer can increase his or her utility by A consumer can increase his or her utility by purchasing more clams and less of other purchasing more clams and less of other goods when the price of clams fallsgoods when the price of clams falls



• Consuming less when price increases and Consuming less when price increases and more when price decreases explains why the more when price decreases explains why the individual demand slopes ______________individual demand slopes ______________

• If individual demand curve slopes downward, If individual demand curve slopes downward, the market demand curve will slope the market demand curve will slope ______________________________

• Demand curves sloping downward also show Demand curves sloping downward also show __________________of goods and services__________________of goods and services


• The effect of a price change on the quantity The effect of a price change on the quantity consumed is always presentconsumed is always present


• If the good absorbs only a small share of the If the good absorbs only a small share of the consumer’s spending, the substitution effect is consumer’s spending, the substitution effect is essentially the complete explanation of why the essentially the complete explanation of why the individual demand curve of that consumer individual demand curve of that consumer slopes downwardslopes downward

• And, when a good absorbs only a small share of And, when a good absorbs only a small share of the typical consumer’s spending, the the typical consumer’s spending, the substitution effect is essentially the sole substitution effect is essentially the sole explanation of why the market demand curve explanation of why the market demand curve slopes downwardslopes downward


• Exceptions are foundExceptions are found

• Goods like ______________ absorb a large Goods like ______________ absorb a large share of a typical consumer’s spendingshare of a typical consumer’s spending

• This makes the individual demand curve and This makes the individual demand curve and the market demand curve become more the market demand curve become more complicatedcomplicated


• As said, for the majority of goods, the As said, for the majority of goods, the substitution effect is sole reason behind substitution effect is sole reason behind the individual and market demand the individual and market demand curvescurves

• ___________________are exceptions ___________________are exceptions due to the amount consumers have to due to the amount consumers have to spendspend


• Example:Example:

• This will have a ______________ effect This will have a ______________ effect (other things equal) the family will have an (other things equal) the family will have an incentive to consume less housing and more incentive to consume less housing and more of other goodsof other goods


• The family though will be made poorer by the The family though will be made poorer by the higher housing price – its income will buy less higher housing price – its income will buy less housing than beforehousing than before

• The amount of income adjusted to reflect its The amount of income adjusted to reflect its true purchasing power is termed “real income”true purchasing power is termed “real income”

• The reduction in the consumer’s real income will The reduction in the consumer’s real income will have an additional effect on the family’s have an additional effect on the family’s consumption bundle, including its consumption consumption bundle, including its consumption of housingof housing


• The income effect of a change in the price of a The income effect of a change in the price of a good is the change in the quantity of that good good is the change in the quantity of that good consumed that results from a change in the consumed that results from a change in the consumer’s purchasing power due to the change consumer’s purchasing power due to the change in the price of that goodin the price of that good

• In this example, a change in the price of a good In this example, a change in the price of a good effectively changes a consumer’s income effectively changes a consumer’s income because it alters the consumer’s purchasing because it alters the consumer’s purchasing powerpower


• The distinction between substitution effect The distinction between substitution effect and income effect:and income effect:

1.1.


2. 2.

• The vast majority of goods are normal The vast majority of goods are normal goods, goods for which demand decreases goods, goods for which demand decreases when income fallswhen income falls


• For an inferior good, For an inferior good,

• The substitution effect tends to produce a The substitution effect tends to produce a _____________ in the quantity of any good _____________ in the quantity of any good demanded as its price ____________ but for demanded as its price ____________ but for an inferior good, the income effect of a price an inferior good, the income effect of a price increases tends to produce an ___________ increases tends to produce an ___________ in the quantity _______________in the quantity _______________


• As a result of all of this, there a As a result of all of this, there a hypothetical cases involving inferior hypothetical cases involving inferior goods in which distinction between goods in which distinction between income and substitution effects are income and substitution effects are importantimportant

• Typically, income effects are important Typically, income effects are important only for a limited number of goodsonly for a limited number of goods

Income and Substitution Effect. Marginal Utility and the Law of Demand Price of fried clams rises Price of fried clams rises Does it change the marginal.

Documents

price of clams

marginal utility

fewer clams

price increases

price decreases

additional pound of

individual demand slopes

downward demand curves