Changes in Income An increase in income will

Changes in Income An increase in income will cause the budget constraint out in a parallel manner l Since PX/PY does not change, the MRS will stay constant as the worker moves to higher levels of satisfaction l

Increase in Income l If both X and Y increase as income rises, X and Y are normal goods Quantity of Y As income rises, the individual chooses to consume more X and Y B C A U 3 U 1 U 2 Quantity of X

Increase in Income l If X decreases as income rises, X is an inferior good As income rises, the individual chooses to consume less X and more Y Quantity of Y Note that the indifference curves do not have to be “oddly” shaped. The assumption of a diminishing MRS is obeyed. C B U 3 U 2 A U 1 Quantity of X

Engel’s Law l Using Belgian data from 1857, Engel found an empirical generalization about consumer behavior l The proportion of total expenditure devoted to food declines as income rises l food is a necessity whose consumption rises less rapidly than income

Substitution & Income Effects l Even if the individual remained on the same indifference curve when the price changes, his optimal choice will change because the MRS must equal the new price ratio l the l substitution effect The price change alters the individual’s “real” income and therefore he must move to a new indifference curve l the income effect

Changes in a Good’s Price l A change in the price of a good alters the slope of the budget constraint l it also changes the MRS at the consumer’s utility-maximizing choices l When the price changes, two effects come into play l substitution effect l income effect

Changes in a Good’s Price Suppose the consumer is maximizing utility at point A. Quantity of Y If the price of good X falls, the consumer will maximize utility at point B. B A U 2 U 1 Quantity of X Total increase in X

Changes in a Good’s Price Quantity of Y To isolate the substitution effect, we hold “real” income constant but allow the relative price of good X to change B A The substitution effect is the movement from point A to point C C U 2 U 1 The individual substitutes good X for good Y because it is now relatively cheaper Quantity of X Substitution effect

Changes in a Good’s Price Quantity of Y The income effect occurs because the individual’s “real” income changes when the price of good X changes B A The income effect is the movement from point C to point B C U 2 U 1 If X is a normal good, the individual will buy more because “real” income increased Quantity of X Income effect

Changes in a Good’s Price Quantity of Y An increase in the price of good X means that the budget constraint gets steeper C A The substitution effect is the movement from point A to point C B U 1 U 2 The income effect is the movement from point C to point B Quantity of X Substitution effect Income effect

Price Changes for Normal Goods l If a good is normal, substitution and income effects reinforce one another l When price falls, both effects lead to a rise in QD l When price rises, both effects lead to a drop in QD

Price Changes for Inferior Goods If a good is inferior, substitution and income effects move in opposite directions l The combined effect is indeterminate l l When price rises, the substitution effect leads to a drop in QD, but the income effect leads to a rise in QD l When price falls, the substitution effect leads to a rise in QD, but the income effect leads to a fall in QD

Giffen’s Paradox l If the income effect of a price change is strong enough, there could be a positive relationship between price and QD l An increase in price leads to a drop in real income l Since the good is inferior, a drop in income causes QD to rise l Thus, a rise in price leads to a rise in QD

Summary of Income & Substitution Effects l Utility maximization implies that (for normal goods) a fall in price leads to an increase in QD l The substitution effect causes more to be purchased as the individual moves along an indifference curve l The income effect causes more to be purchased because the resulting rise in purchasing power allows the individual to move to a higher indifference curve

Summary of Income & Substitution Effects l Utility maximization implies that (for normal goods) a rise in price leads to a decline in QD l The substitution effect causes less to be purchased as the individual moves along an indifference curve l The income effect causes less to be purchased because the resulting drop in purchasing power moves the individual to a lower indifference curve

Summary of Income & Substitution Effects l Utility maximization implies that (for inferior goods) no definite prediction can be made for changes in price l The substitution effect and income effect move in opposite directions l If the income effect outweighs the substitution effect, we have a case of Giffen’s paradox

The Individual’s Demand Curve Quantity of Y As the price of X falls. . . PX …quantity of X demanded rises. PX 1 PX 2 PX 3 U 1 X 1 I = PX 1 + PY X 2 U 2 X 3 I = PX 2 + PY U 3 Quantity of X I = PX 3 + PY d. X X 1 X 2 X 3 Quantity of X

The Individual’s Demand Curve l An individual demand curve shows the relationship between the price of a good and the quantity of that good purchased by an individual assuming that all other determinants of demand are held constant

Shifts in the Demand Curve l Three factors are held constant when a demand curve is derived l income l prices of other goods l the individual’s preferences l If any of these factors change, the demand curve will shift to a new position

Shifts in the Demand Curve l A movement along a given demand curve is caused by a change in the price of the good l called l a change in quantity demanded A shift in the demand curve is caused by a change in income, prices of other goods, or preferences l called a change in demand