income effect and substitution effect primer
Post on 19-Oct-2014
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DESCRIPTION
The TWO main reasons the Demand Curve is downward sloping.TRANSCRIPT
INCOME AND SUBSTITUTION EFFECTSAn explanation of why the DEMAND Curve is DOWNWARD sloping
The INCOME EFFECT of a DECREASE in the Price of a Good
Income to Spend on this good = $50
Price Quantity Demanded$10 5$5 10$2 25
“Income Effect” ExplainedNOT to be confused with Changes in Income (that will SHIFT the Demand Curve)!!
To determine the Income Effect you want to consider the Purchasing Power of your income relative to price changes for a good.
Here is a DEMAND SCHEDULE showing the various Quantities Demanded at different Prices
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
If we graph the points from the DEMAND SCHEDULE we get a Market Demand Curve like this…
Income to Spend on this good = $50Price Quantity Demanded$10 5$5 10$2 25
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
Assume that something happens on the Supply-Side (not shown on this graph) in the production of this good that DECREASES the cost of producing this good and the price of the good decreases from $5.00 to $2.00.
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
Remember the LAW OF DEMAND!
When the PRICE of a good DECREASES the QUANTITY DEMANDED of the good INCREASES.
There is an INVERSE relationship between PRICE and QUANTITY DEMANDED
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
When the Price Decreases to $2.00 the Quantity Demanded of this good Increases to 25—Point “C”. While our income spent on this good ($50.00) did not change, the purchasing power of that $50.00 Increased---at a lower price we can buy more.
This is known as the “INCOME EFFECT” of a change in Price.
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
. NOTE: As a result, we moved ALONG the Demand Curve, from Point “B” to “C”. The Demand Curve did not shift! The “Effect” here was on the purchasing power of our unchanged income. If our income had changed, then the Demand curve would have shifted Right (Increase in income) or Left (Decrease in income)
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
We are NOT buying MORE at $5.00 , but we are increasing our Quantity Demanded to 25 ONLY because the price decreased to $2.00.
The INCOME EFFECT of an INCREASE in the Price of a Good
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
Assume that something happens on the Supply-Side (not shown on this graph) in the production of this good that INCREASES the cost of producing this good and the price of the good increases from $5.00 to $10.00.
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
Remember the LAW OF DEMAND!
When the PRICE of a good INCREASES the QUANTITY DEMANDED of the good DECREASES.
There is an INVERSE relationship between PRICE and QUANTITY DEMANDED
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
When the Price increases to $10.00 the Quantity Demanded of this good decreases to 5—Point “C”. While our income spent on this good ($50.00) did not change, the purchasing power of that $50.00 decreased---at a higher price we can buy less.
This is known as the “Income Effect” of a change in Price
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
NOTE: As a result, we moved ALONG the Demand Curve, from Point “B” to “A”. The Demand Curve did not shift! The “Effect” here was on the purchasing power of our unchanged income. If our income had changed, then the Demand curve would have shifted Right (Increase in income) or Left (Decrease in income)
PriceOf Good #1
Quantity of Good#1
Market for Good #1
$10.00
$5.00
$2.00
10 255
“B”
“A”
“C”
Demand*
We are NOT buying LESS at $5.00 , but we are decreasing our Quantity Demanded to 5 ONLY because the price increased to $10.00.
Substitution EffectIs dependent on the availability of a viable Substitute.
Price of Chicken
Price of BEEF
D*D*
100
Quantity of Chicken Quantity of BEEF100
$1.00 $1.00“A”“A”
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
Price of Chicken
Price of BEEF
D*D*
100
Quantity of Chicken Quantity of BEEF100
$1.00 $1.00“A”“A”
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
Chicken and Beefcurrently are the SAME price per pound
At $1.00 the Quantity Demanded for each is 100lbs
Price of Chicken
D*D*
100
Quantity of Chicken
10075
$1.00 $1.00
$1.25
“A”“A”
“C”
Quantity of BEEF
Price of BEEF
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
Assume the Price ofBeef INCREASES to $1.25.
At $1.25 the Quantity DemandedFor Beef is 75lbs. (Point “C”)
A Change in the Price of Beef relative to the Price of Chicken
Price of Chicken
D*D*
100
Quantity of Chicken
10075
$1.00 $1.00
$1.25
“A”“A”
“C”
Quantity of BEEF
Price of BEEF
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
What happened to the Consumers who bought 25 fewer pounds of BEEF?They still want protein, right?
Price of Chicken
D*D*
100
Quantity of Chicken
10075
$1.00 $1.00
$1.25
“A”“A”
“C”
Quantity of BEEF
Price of BEEF
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
Because Chicken is now RELATIVELYCHEAPER at $1.00 per pound than Beef ($1.25), Then consumers purchase 25 llbs MOREOf Chicken at $1.00 than they did before.
Price of Chicken
D*D*
100
Quantity of Chicken
100125 125
$1.00 $1.00
$1.25
“A”“A” “B”
“C”
D 1
Quantity of BEEF
Price of BEEF
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
At $1.00 the Quantity Demanded for Chicken is 125llbs.An INCREASE of 25 pounds. Notice we did not move ALONG The Demand Curve for Chicken, but to a point to the RIGHT (“B”)This means the DEMAND for Chicken has INCREASED.
Price of Chicken
D*D*
100
Quantity of Chicken
100125 125
$1.00 $1.00
$1.25
“A”“A” “B”
“C”
D 1
Quantity of BEEF
Price of BEEF
A Change in DEMAND VS A Change in QUANTITY DEMANDED(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
“At $1.00 the Quantity Demanded For Chicken is GREATER than before.
(125 vs 100)We assume it will be as well at
EVERY OTHER PRICE!DEMAND Curve has shifted to the RIGHT
Price of Chicken
D*D*
100
Quantity of Chicken
100125 125
$1.00 $1.00
$1.25
“A”“A” “B”
“C”
D 1
Quantity of BEEF
Price of BEEF
(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
Bottom Line: Because of the availability of a Substitute (Chicken), an INCREASEIn the Price of Beef caused a DECREASE in the Quantity Demanded for Beef—Movement ALONG the Demand Curve for Beef (“Substitution Effect”) and INCREASEDThe DEMAND for Chicken (shift of the Demand Curve for Chicken to the RIGHT)
Price of Chicken
D*D*
100
Quantity of Chicken
10075 125
$1.00 $1.00
$.75
“A”“A”“B”
“C”
D 1
Quantity of BEEF
Price of BEEF
(Substitutes) (Substitution Effect)
A Change in the Price of Beef relative to the Price of Chicken
NOTE: The same principle applies if the price of Beef DECREASES. The Quantity Demanded for Beef INCREASES (Substitution Effect—move along the Demand Curve down And to the Right) and the Demand for Chicken DECREASES (shifts to the LEFT). People who formerly bought 100lbs of Chicken (now only 75lbs) before will by 25 additional pounds of Beef (now 125lbs) ONLY because the Price of Beef is cheaper!
Combining the Income and Substitution Effects.
• Here is an EXCELLENT Video that takes this explanation a bit further. It is important to view it to complete your understanding of these two effects. Worth the time!
• https://www.youtube.com/watch?v=a4VvgPL_LB0
• Or Google “Office Hours: Substitution and Income Effect dmateer”