Siteadmin, Bureaucrats, Check users, nsAm_Govt_101RO, nsAm_Govt_101RW, nsAm_Govt_101_ta, nsJudgesRO, nsJudgesRW, nsJudges_talkRO, nsJudges_talkRW, nsTeam2RO, nsTeam2RW, nsTeam2_talkRO, nsTeam2_talkRW, oversight, Administrators
125,790
edits
Changes
Jump to navigation
Jump to search
Line 22:
Line 22: − + − + + + + + + + + + + + − 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. + − + + + − − 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.
Economics Lecture Four (view source)
Revision as of 02:26, September 19, 2009
, 02:26, September 19, 2009→Income and Substitution Effects, and the Law of Demand: done
The moral of this 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 based on your personal preferences rather than market demand.
The moral of this 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 based on your personal preferences rather than market demand.
==Income and Substitution Effects, and the Law of Demand==
== '''''Why''''' the Law of Demand Is True: Income & Substitution Effects==
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.”
Recall that 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.
The question we ask and answer now is this: '''''why''''' is the Law of Demand true? We have discussed in class two reasons.
First, the more expensive something becomes, the less people can '''''afford''''' to buy it. Someone with access to a maximum of $10,000 (in wealth or loans) cannot purchase a good costing $20,000. He cannot afford it. Actually, this person probably cannot afford anything more expensive than about $5,000, because he needs to use his other money for food and shelter and clothing and transportation.
The second reason for the Law of Demand is that even people who can afford something may prefer, as the price of a good increases, to spend their money on an alternative instead. People who can afford to spend $20,000 on a luxury cruise may look at that price and decide to spend that money in a more enjoyable manner, such as renting house at the Jersey shore one week each summer for the next 20 years.
These two reasons, or effects, have been given names in economics. They are called the income and substitution effects. They cause the important "Law of Demand." Let's examine each effect now.
The “income effect” is the effect that a change in price of a good has on a buyer's overall income. When the price of a good decreases, a buyer of the good saves money. This is the same as if he earned more money. "A penny saved is a penny earned." When the price of a good decreases by a penny, the "income effect" is as though the buyer earned an extra penny in income. 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.
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.
To summarize: the income effect of a decrease in price is to allow the buyer to save more money, and some buyers will use that savings to purchase more of the good. If you went to the store to buy a new pair of socks for $5, and found they were on sale for only $2.50, then you may use that savings to buy two pairs of socks. This "income effect" of a decrease in price causes demand to increase for the good.
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.
The second reason that the Law of Demand is true is because a decrease in price of a good also causes a “substitution effect”. Think of what happens when the price of a good increases. People start to buy substitutes instead, and so the demand for the good with the higher price decreases. Similarly, when the price of a good decreases, people want to buy more of the less expensive 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. This is typical.
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.
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.
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.
== Bizarre Exceptions ==
== Bizarre Exceptions ==