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5Chapter outline5.1 How Income Changes Affect an Individual’s Consumption Choices5.2 How Price Changes Affect Consumption Choices5.3 Decomposing ConsumerResponses to Price Changes into
Income and Substitution Effects5.4 The Impact of Changes in Another Good’s Price 5.5 Combining Individual Demand Curves to Obtain the Market Demand Curve5.6 Conclusion
The income effect is the change in optimal consumption choices associated with a change in income (or purchasing power), holding relative prices constant
Is higher income associated with higher consumption of goods?
It depends!
For normal goods, higher income is associated with rising consumption•For instance, consider Fancy Meals and Vacations, both of which are considered normal goods
5How Income Changes Affect an Individual’s Consumption Choices
The income effect is the change in optimal consumption choices associated with a change in income (or purchasing power), holding relative prices constant
Is higher income associated with higher consumption of goods?
It depends!
For normal goods, higher income is associated with rising consumption
Alternatively, for inferior goods, higher income is associated with falling consumption•Consider boxed macaroni and cheese (inferior good) vs. steak (a normal good)
5How Income Changes Affect an Individual’s Consumption Choices
Chapter 2 introduced the concept of elasticity•Income elasticity describes the response of demand to changing income•Specifically, the percentage change in quantity consumed associated with a percentage change in income
Mathematically,
where I is income and Q is the quantity of a good demanded
The income effect is given by
5How Income Changes Affect an Individual’s Consumption Choices
While usually not priced in the market, consumers have preferences for environmental quality just like any other good•Most economists believe the environment is a normal good•Poorer countries are often characterized by environmentally damaging industrial processes; perhaps citizens are choosing improved income over environmental quality•As income-per-capita improves, pollution should fall•This hypothesis is known as the “Environmental Kuznets Curve” (EKC)
Vollebergh, et al. (2009) find evidence for the EKC for sulfur dioxide emissions in a panel of OECD countries
They find no similar evidence for carbon dioxide
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Citation: Vollebergh, H. R. J., Melenberg, B., and Dijkgraff, E. 2009. “Identifying reduced form relations with panel data: The case of pollution and income.” Journal of Environmental Economics and Management 58: 27-42.
Citation: Vollebergh, H. R. J., Melenberg, B., and Dijkgraff, E. 2009. “Identifying reduced form relations with panel data: The case of pollution and income.” Journal of Environmental Economics and Management 58: 27-42.
Income per capita
The Inverted U-Shape
Pollution per-capita
As income rises, pollution will rise at first because consumers are trading off environmental protection for other goods
Eventually, as income hits some threshold, consumers demand greater environmental protection
At this point, pollution-per-capita begins to fall
Caveats:•Because markets for environmental goods and services are often lacking or non-existent, they are often under-supplied •Without strong property rights or an effective central authority, the EKC hypothesis will likely fail•Additionally, as income grows, production processes generally become more efficient on their own, and economies transition to less polluting service sectors•Many economists dispute the presence of a demand-driven inverted U-shape for most pollutants
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Citation: Vollebergh, H. R. J., Melenberg, B., and Dijkgraff, E. 2009. “Identifying reduced form relations with panel data: The case of pollution and income.” Journal of Environmental Economics and Management 58: 27-42.
Tracing the optimal bundle of goods chosen as income increases results in the income expansion path•Helps determine whether a good is normal or inferior, but only two goods represented•Can’t directly observe income levels on the curve (both axes represent quantities of goods)
A more common way to describe the consumption-income relationship is with an Engel curve•Shows the relationship between quantity consumed of one good and consumer income
5How Income Changes Affect an Individual’s Consumption Choices
Citation: Vollebergh, H. R. J., Melenberg, B., and Dijkgraff, E. 2009. “Identifying reduced form relations with panel data: The case of pollution and income.” Journal of Environmental Economics and Management 58: 27-42.
Income per capita
The EKC Hypothesis revisited
Pollution per-capita
Returning to the previous example, we can uncover how the U-shape is equivalent to an Engle curve by switching the axes
While environmental quality is a normal good, pollution is an inferior good, as the shape of this curve suggests
Just as income affects consumer choices, changes in relative prices—holding income constant—also affects these choices
Deriving a Demand Curve•Demand curves define a relationship between quantity demanded and price•To derive a demand curve, we must understand how a consumer responds to a change in price•By changing one price on an indifference curve – budget constraint map, we can observe changes to consumer choices and then build the demand curve for an individual•The observed price represents the maximum willingness to pay for the last unit consumed
When consumer preferences, income, or the prices of other goods change, the demand curve will shift
Consider the example of Mountain Dew and grape juice from the previous figure•Imagine the consumer prefers the taste of Mountain Dew, but had previously limited consumption due to worries about high fructose corn syrup•After hearing advertisements from the Corn Refiners Association claiming corn syrup is identical to cane sugar, her fears are reduced
(a) Caroline’s indifference curves for grape juice flatten when her preference for grape juice decreases relative to her preference for Mountain Dew. At each price level, she now consumes fewer bottles of grape juice.
( b) Because she purchases fewer bottles of grape juice at each price point, Caroline’s demand curve for grape juice shifts inward from D1 to D2.
Mark has $200 per month to spend on movie tickets (M) and theater tickets (T); movie tickets cost $10 each, and theater tickets cost $50 each
a.With theater tickets on the horizontal axis, draw Mark’s budget constraint and indicate the horizontal and vertical intercepts
b.Suppose Mark currently purchases 30 theater tickets. Indicate this choice on the graph with the letter A and draw an indifference curve
c.Now, suppose the price of theater tickets rises to $80. Mark now purchases two theater tickets. Indicate this point with the letter B and draw a new indifference curve
d.Finally, suppose the price of theater tickets rises again to $100. Mark purchases one theater ticket. Indicate this point with the letter C and draw a new indifference curve
e.Draw a new diagram showing Mark’s demand curve for theater tickets
When the price of a good changes relative to another, two things happen1.One good becomes relatively more expensive, and the other relatively less2.The total purchasing power of a consumer’s income changes
The substitution effect refers to the change in consumption choices resulting from a change in relative prices•Always negative; when the price of one good relative to another increases, consumption of the former falls, and vice versa
The income effect refers to the change in consumption choices resulting from a change in purchasing power•This is the same income effect from Section 5.1•Can be negative or positive (inferior or normal goods)
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
The total effect of a change in a price is the sum of the substitution and income effects•The total effect is simply the observed change in consumption of a good after a price change
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
The total effect is the sum of the substitution and income effects•The total effect is simply the observed change in consumption of a good after a price change
Isolating the Substitution Effect•Determine the bundle of goods that would have been chosen at the new price while maintaining utility experienced before the price change•To do this for a fall in the price of restaurant meals, shift the new budget constraint inward until it is tangent with the old indifference curve
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
The total effect is the sum of the substitution and income effects•The total effect is simply the observed change in consumption of a good after a price change
Isolating the Substitution Effect•Determine the bundle of goods that would have been chosen at the new price while maintaining utility experienced before the price change•For a fall in the price of restaurant meals, shift the new budget constraint inward until tangent with the old indifference curve•Restaurant meals are normal goods; therefore, the income effect is positive
Isolating the Income Effect•The income effect is the total effect minus the substitution effect
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
Three steps to computing substitution and income effects associated with a price change. Starting with a consumer at bundle A1.Draw the new budget constraint and find the new optimal bundle (B )
• A price change for one of two goods rotates or pivots the constraint
2.Draw a line parallel to the new budget constraint, but tangent to the old indifference curve; determine the optimal bundle on the old curve associated with this theoretical budget constraint (A′)3.The substitution effect is the difference in quantities between A and A′ and the income effect is the difference in quantities between A′ and B
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
What Determines the Size of the Substitution and Income Effects?
Curvature: The size of the substitution effect depends on the curvature of indifference curvesWhat does it mean when an indifference curve is relatively straight?What does this say about the size of the MRS along a straighter curve?Is the substitution effect larger or smaller along a straighter curve?
Quantity consumed before the price change: The income effect increases with the amount spent on a good before a price changeWhy does the income effect increase with the amount spent on a good?
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
Monica eats chips and crackers. Her income is $20, and the price of chips and crackers are $1 and $2 per bag, respectively.
At these prices, she eats 16 bags of chips and two bags of crackers (point A )
When the price of crackers falls to $1, Monica consumes 8 bags of chips and 12 bags of crackers (point B )
0 4 Crackers
Chips 20Answer the following1.Why does the budget constraint rotate?2.Label your own diagram and estimate the income and substitution effects for crackers. Which is larger?3.Are crackers a normal or inferior good? Chips?
1. The price of chips has not changed, and so Monica can still buy 20 bags of chips if she so chooses; however, she can now afford twice as many crackers (20 bags)
2. The substitution effect is measured by holding utility at the pre-change level, and considering Monica’s optimal bundle with the new price ratio, A′
0 4 Crackers
Chips 20The income effect is the remainder of the difference between A and B. The income effect is larger for crackers.
3.Crackers are a normal good since Monica purchases more when her purchasing power increases (the income effect is positive)
Chips, on the other hand, are inferior; Monica purchases fewer chips when her purchasing power increases
Citation: Shogren, J. F., Shin, S. Y., Hayes, D. J., and Kliebenstein, J. B. 1994. “Resolving Differences in Willingness to Pay and Willingness To Accept.” The American Economic Review 84(1): 255-270.
Price Changes and Willingness to Pay In addition to providing insight to income
and substitution effects, the previous graphical analysis reveals information about how price changes affect consumer welfare
Consider again the price change in crackers for Monica; she is clearly better off; her new budget constraint contains a larger set of feasible bundles
Exactly how much better off is she?
Simple: by the amount of income we could take away, leaving Monica at her original utility level!
We call this compensating variation, and it looks to be about $3 in this case
Monica should be willing to pay $3 to experience a lower price on crackers, and she should be willing to accept $3 in lieu of the price change
The theoretical equivalency between willingness to pay (WTP) and willingness to accept (WTA) extends to quantity differences
In practice, however, WTA for a product a consumer currently owns generally exceeds WTP for that same product
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Citation: Shogren, J. F., Shin, S. Y., Hayes, D. J., and Kliebenstein, J. B. 1994. “Resolving Differences in Willingness to Pay and Willingness To Accept.” The American Economic Review 84(1): 255-270.
Citation: Shogren, J. F., Shin, S. Y., Hayes, D. J., and Kliebenstein, J. B. 1994. “Resolving Differences in Willingness to Pay and Willingness To Accept.” The American Economic Review 84(1): 255-270.
Giffen goods are goods for which quantity demanded increases as price rises•Inferior goods, but the income effect outweighs the substitution effect•Results in an upward sloping demand curve
When the price of a Giffen good drops, the substitution effect (which acts to increase demand) is smaller than the income effect
Economists sometimes question whether Giffen goods actually exist•The few examples with humans tend to focus on very poor households and commodity crops (e.g., rice and potatoes)
5Decomposing Consumer Responses to Price Changes into Income and Substitution Effects
Battalio, et al. (1990) found existence of Giffen behavior in rats using quinine solution (tonic water) and root beer•Rats prefer root beer to water, and water to quinine solution
Rats were given limited “lever-pulls” to release liquid, and root beer pulls released less liquid than the quinine pull (no water was available during the experiment)
Findings imply quinine solution is a Giffen good for rats•First, quinine solution was shown to be an inferior good (negative income effect)•Second, when the price of quinine solution was lowered (more volume per pull), the average rat reduced volumetric consumption, shifting to root beer instead
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Citation: Battalio, R. C., Kagel, J. H., and Kogut, C. A. 1991. “Experimental Confirmation of the Existence of a Giffen Good.” The American Economic Review 81(4): 961-970.
The final step linking consumer theory to market demand is probably the easiest•Market demand is the horizontal sum of individual demand curves•The market quantity demanded at each price is the sum of the individual quantities demanded at each price•The market demand curve is found by summing horizontally individual demand curves
Consider the market for scooters
5Combining Individual Demand Curves to Obtain the Market Demand Curve
The final step linking consumer theory to market demand is the easiest•Market demand is simply the sum of individual demand•The total quantity demanded at each price is the sum of every individual’s quantity demanded at each price•The market demand curve is found by summing horizontally individual demand curves
Consider the market for scooters
Algebraically, market demand is given by
The difference in choke prices implies your demand function is the market demand function for prices between $52 (cousin’s choke price) and $100 (your choke price); the market demand function applies to prices less than $52
5Combining Individual Demand Curves to Obtain the Market Demand Curve
This chapter concludes our in-depth analysis of the consumer side of the supply and demand model. We•Examined how income and prices affect consumer choices•Made the link between consumer theory and market demand
In Chapter 6 we begin a parallel in-depth examination of producer behavior