2.3 Income/Price Changes & Income and Substitution effects

2.3.1 Income Consumption Curves2.3.2 Price Consumption Curves2.3.3 Income and Substitution

Effects2.3.4 Application with Different

Types of Goods

Application

“Household prices and the great affordability gap” The Times 5th September 2007

•House prices rising far faster than earnings

•In UK, three times faster

•Price of housing rising so proportion spent on it rises

•Similar patterns happening across developed economies

2.3.1 Income Consumption Curves

If income changes, BC shifts in a parallel fashion (in or out)

If Price changes, BC pivots (in or out)

QB

QABC1BC2 BC3

Income Consumption Curve

Curve shows preference for a good

An example: Engel Curves

Food Spend

Income

As income rises, proportion spent on food declines

QB

QA

U1

U2U3

A1 A2 A3

(Or all other goods)

BC1BC2 BC3

Price Consumption Curve

2.3.2 Price Consumption Curves

0

Note that at A1:

2OBCY

PA

At A2:

1OBCY

PA

At A3:

3OBCY

PA

PA

QA

X

X

X

A1 A2 A3

Y/OBC1

Y/OBC2

Y/OBC3

PRICE DEMAND CURVE

Position of the demand curve depends on:

1. Income levels - higher Y is further right D curve is

2. Tastes - stronger these are, further right the D curve

3. Prices of other goods - substitutes and complements

In a demand relationship the quantity consumed changes with price but what does the quantity change actually consist of?

Substitution Effect - substitute other goods for A as Price of A rises

Income Effect - as price of A falls, real income rises and so spend more on all goods

2.3.3 Income and Substitution Effects

Direction and size of effects varies with type of good

Normal Good - as price falls, consumption rises

- as income rises, consumption rises

Inferior Good - as price falls, consumption rises

- as income rises, consumption falls

Giffen Good - as price falls, consumption falls

- as income rises, consumption falls

2.3.4 Application to Different Types of Goods

Other Goods

QA

U1

U2

BC2

BC11 3 2

Normal Good

Subs: 1 to 3 or A to C (-ve)

Income: 3 to 2 or C to B (+ve)

Price effect: A to B or 1 to 2

A

B

C

BC3

Other Goods

QA

U1

U2

BC2

BC1 BC32 3

AB

C

Inferior Good

Subs: 1 to 3 or A to C (-ve)

Income: 3 to 2 or C to B (-ve)

Price effect: A to B or 1 to 2

1

Other Goods

QA

U2

U1BC2

BC1 BC31 32

A

B

C

Giffen GoodSubs: 1 to 3 or A to C (-ve)

Income: 3 to 2 or C to B (-ve)

Price effect: A to B or 1 to 2

Other Goods

Housing

U1BC2

BC1

U2

BC3H1 H2

Q1

Housing Market Revisited