Changes

The moral of the story:  learn to look beyond your own situation when making buying and selling decisions.  You may think a particular house is the best thing in the world, but if the market values that house less than you do, then you'll lose money if you buy it.

The moral of the story:  learn to look beyond your own situation when making buying and selling decisions.  You may think a particular house is the best thing in the world, but if the market values that house less than you do, then you'll lose money if you buy it.

==Income and Substitution Effects==

==Income and Substitution Effects, and the Law of Demand==

When the real price of a good decreases, there are two main economic effects.  First, it increases the real income of consumers because they do not have to spend as much on the good.  For example, if you drink a gallon of milk each week and the price of that gallon decreases by 25 cents, then you have 25 cents extra to spend on something else.  It is as though your income went up by 25 cents.  This is called the “income effect.”

When the real price of a good decreases, there are two main economic effects.  First, it increases the real income of consumers because they do not have to spend as much on the good.  For example, if you drink a gallon of milk each week and the price of that gallon decreases by 25 cents, then you have 25 cents extra to spend on something else.  It is as though your income went up by 25 cents.  This is called the “income effect.”

Remember how we discussed that an increase in income usually causes people to buy more of a good?  Now that you have more income, you may want to buy more milk.  Instead of drinking a gallon a week, perhaps you can now afford to drink a gallon and a quart a week.  The decrease in price of milk created an income effect (increase in income), which encourages you to buy more milk.

Remember how we discussed that an increase in income usually causes people to buy more of a good?  Now that you have more income, you may want to buy more milk.  Instead of drinking a gallon a week, perhaps you can now afford to drink a gallon and a quart a week.  The decrease in price of milk created an income effect (increase in income), which encourages you to buy more milk.

Second, the decrease in price of a good causes a “substitution effect”.  You may want to buy more of the good instead of something else.  In the milk example, its cheaper price makes it more attractive to purchase.  You may want to substitute milk for the fruit juice you used to drink.   

Second, the decrease in price of a good causes a “substitution effect”.  You may want to buy more of the good instead of something else.  In other words, a decrease in price of a good makes you more willing to buy it as a "substitute" for a similar good.  In the milk example, its cheaper price makes it more attractive to purchase.  You may want to substitute milk for the fruit juice you used to drink.   

Both the “income effect” and the “substitution effect” give you an incentive to buy more of the good that decreased in price.  The overall increase in quantity demanded for a good that cut its price is the sum of the income effect and the substitution effect.  For a normal good, a decrease in its price causes an increase in real income (the income effect) and an increase in substitution for other goods (the substitution effect), which add together to cause an overall increase in demand.

Both the “income effect” and the “substitution effect” give you an incentive to buy more of the good that decreased in price.  The overall increase in quantity demanded for a good that cut its price is the sum of the income effect and the substitution effect.  For a normal good, a decrease in its price causes an increase in real income (the income effect) and an increase in substitution for other goods (the substitution effect), which add together to cause an overall increase in demand.

Is that true for all goods? Last class, we mentioned an odd type of good known as an “inferior” good.  You may recall that the demand for an “inferior” good actually increases when income decreases.  Examples are margarine (because people with declining income can less afford butter).  Bankruptcy services are “inferior”, because the greater the decline in income, the more people who file for bankruptcy, and the greater the demand for those services.  If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

Learn these two important concepts well -- the income effect and substitution effect.  In understanding concepts, it helps to restate them slightly differently until there is a full appreciation of them.  The “income effect” is the change in your wealth (income) due to a change in price of something you buy, AND how that change effects what you buy.  If the price of milk decreases, then the “income effect” is to make you feel like you have more income AND enable you to buy more milk and other goods.  If the price of milk increases, then the “income effect” is to make you feel like you have less income because you had to spend more on buying the milk, leaving you less money to spend on other things.  Understand this?  Reread it again if necessary, and think about how a change in the price of milk affects your decisions about how much milk and other things you can buy.

 

The “substitution effect” is the change in substitution (one good for another) due to the change in price of one of the two goods.  If the price of a good decreases, then that price change makes it more attractive to be used as a substitute for another good.  If, for example, chicken sandwiches are on sale at half-price at McDonalds, then more customers are going to choose chicken sandwiches as a substitute for hamburgers.  The decrease in price of chicken sandwiches has a “substitution effect” of causing more people to buy them as they move from eating hamburgers to eating the cheaper chicken sandwiches.

 

These two effects -- the income and substitution effects -- result in the important "Law of Demand."  '''The “Law of Demand” is this: when the price of a good increases, its demand decreases.  When the price of a good decreases, its demand increases.''' This is one of the most fundamental rules of Economics.

 

 

 

Last class, we mentioned an odd type of good known as an “inferior” good.  You may recall that the demand for an “inferior” good actually increases when income decreases.  Examples are margarine (because people with declining income can less afford butter).  Bankruptcy services are “inferior”, because the greater the decline in income, the more people who file for bankruptcy, and the greater the demand for those services.  If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

Ponder that question further.  From above, the overall change in quantity demanded is a sum of the “income effect” and the “substitution effect.”  The “income effect” when the price decreases is that real income goes up.  But for an “inferior” good, an increase in income means a decrease in demand!  That’s strange.  The price decreases, but the demand due to the income effect of that price decrease also decreases.   

Ponder that question further.  From above, the overall change in quantity demanded is a sum of the “income effect” and the “substitution effect.”  The “income effect” when the price decreases is that real income goes up.  But for an “inferior” good, an increase in income means a decrease in demand!  That’s strange.  The price decreases, but the demand due to the income effect of that price decrease also decreases.   

Other economists suggest that tortillas are a Giffen good in Mexico today.  But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods.  Rice and noodles are now described as Giffen goods among the poor in China.  Do you believe it?

Other economists suggest that tortillas are a Giffen good in Mexico today.  But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods.  Rice and noodles are now described as Giffen goods among the poor in China.  Do you believe it?

Except for the rare and possibly non-existent Giffen good, the “Law of Demand” is this: when the price of a good increases, its demand decreases. When the price of a good decreases, its demand increases. This is one of the most fundamental rules of Economics.

These are exceptions to the Law of Demand ... if they really exist!

==Utility==

==Utility==