2 3 IncomePrice Changes Income and Substitution effects

2. 3 Income/Price Changes & Income and Substitution effects 2. 3. 1 2. 3. 2 2. 3. 3 2. 3. 4 Income Consumption Curves Price Consumption Curves Income and Substitution Effects Application with Different Types of Goods

Application “Household prices and the great affordability gap” The Times 5 th 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 Income Consumption Curve shows preference for a good BC 1 BC 2 BC 3 QA

An example: Engel Curves Food Spend As income rises, proportion spent on food declines Income

2. 3. 2 Price Consumption Curves QB U 2 U 3 U 1 (Or all other goods) Price Consumption Curve 0 A 1 A 2 A 3 BC 1 BC 2 BC 3 QA

Note that at A 1: At A 2: At A 3: PA Y/OBC 1 X Y/OBC 2 PRICE DEMAND CURVE X Y/OBC 3 X A 1 A 2 A 3 QA

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

2. 3. 3 Income and Substitution Effects 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. 4 Application to Different Types of Goods 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

Other Goods U 2 Normal Good Subs: 1 to 3 or A to C (-ve) U 1 Income: 3 to 2 or C to B (+ve) Price effect: A to B or 1 to 2 B A C BC 2 1 3 2 BC 1 BC 3 QA

Other Goods Inferior Good Subs: 1 to 3 or A to C (-ve) Income: 3 to 2 or C to B (-ve) B Price effect: A to B or 1 to 2 A U 2 C U 1 BC 2 1 2 3 BC 1 BC 3 QA

Giffen Good Subs: 1 to 3 or A to C (-ve) Other Goods Income: 3 to 2 or C to B (-ve) Price effect: A to B or 1 to 2 B A U 2 C U 1 2 1 3 BC 1 BC 3 BC 2 QA

Housing Market Revisited Other Goods Q 1 U 2 BC 2 H 1 H 2 BC 1 BC 3 Housing