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2.3 Income/Price Changes & Income and Substitution effects

2.3 Income/Price Changes & Income and Substitution effects. 2.3.1 Income Consumption Curves 2.3.2 Price Consumption Curves 2.3.3 Income and Substitution Effects 2.3.4 Application with Different Types of Goods. Application

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2.3 Income/Price Changes & Income and Substitution effects

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  1. 2.3 Income/Price Changes & Income and Substitution effects 2.3.1 Income Consumption Curves 2.3.2 Price Consumption Curves 2.3.3 Income and Substitution Effects 2.3.4 Application with Different Types of Goods

  2. 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

  3. 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 Curve shows preference for a good QA BC2 BC3 BC1

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

  5. 2.3.2 Price Consumption Curves U3 U2 QB U1 (Or all other goods) Price Consumption Curve A2 A3 BC2 BC3 0 QA A1 BC1

  6. Note that at A1: At A2: At A3: PA Y/OBC1 X PRICE DEMAND CURVE Y/OBC2 X Y/OBC3 X QA A1 A2 A3

  7. 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

  8. 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

  9. 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

  10. Other Goods Normal Good U2 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 U1 B A C BC2 1 3 2 BC3 BC1 QA

  11. Other Goods 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 B A U2 C U1 BC2 QA 3 2 BC1 BC3 1

  12. Giffen Good Other Goods 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 B A U2 C U1 BC2 2 3 BC1 BC3 1 QA

  13. Housing Market Revisited Other Goods Q1 U2 U1 BC2 BC1 BC3 H1 H2 Housing

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