Changes

In this course we have already learned about the supply and demand curves, and examined the economic concept of “elasticity”.  Recall that elasticity measures the sensitivity of the quantity demanded to a change in price, as we discussed in the last lecture.   

In this course we have already learned about the supply and demand curves, and examined the economic concept of “elasticity”.  Recall that elasticity measures the sensitivity of the quantity demanded to a change in price, as we discussed in the last lecture.   

This time, we are going to focus on other aspects of “demand”.

In this lecture we focus on other aspects of “demand”.

== The Income and Substitution Effects==

== The Income and Substitution Effects==

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.

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 Law of Demand.

The question we ask and answer now is this:  '''''why''''' is the Law of Demand true?  We have discussed in class two reasons.

The question we ask and answer now is this:  '''''why''''' is the Law of Demand true?  There are 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.

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.

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.

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.

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.

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.

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.

=== For Honors Students Only: Giffen Goods ===

=== For Honors Students Only: Giffen 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.   

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 when income declines, more people file for bankruptcy, and the greater the demand for bankruptcy services.   

'''''Question''''': If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

'''''Question''''': If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

A Giffen good could be an “inferior” good that responds so negatively to an increase in income that the income effect outweighs the substitution effect.  In the 1895 edition of the classic “Principles of Economics,” Alfred Marshall wrote: “As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring [British spelling] families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.”

A Giffen good could be an “inferior” good that responds so negatively to an increase in income that the income effect outweighs the substitution effect.  In the 1895 edition of the classic “Principles of Economics,” Alfred Marshall wrote: “As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring [British spelling] families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.”

Another textbook example of a “Giffen good” is the potato during the terrible Irish famine of 1846-1849.  This famine caused nearly a million Irish to die of starvation, and forced nearly another million to emigrate to the United States, Britain, Canada and Australia.  Economists say that the potato during the famine was Giffen good.  The potato crops failed and there was less supply of potatoes, which caused its price to increase.  But the poor Irish, after paying the higher price for potatoes, had less money left to buy more expensive foods.  So they had no choice but to buy even more potatoes to fill their stomachs!  In other words, the increase in the price of the potato wiped out the savings of the Irish, who then bought even more potatoes despite its increase in price.  Note that the potato could have been a Giffen good only if it was also an “inferior” good that saw a surge in demand when people had less income (less money to spend).

Another textbook example of a “Giffen good” is the potato during the terrible Irish famine of 1846-1849.  This famine caused nearly a million Irish to die of starvation, and forced nearly another million to emigrate to the United States, Britain, Canada and Australia.  Economists say that the potato during the famine was Giffen good.  The potato crops failed and there was less supply of potatoes, which caused its price to increase.  But the poor Irish, after paying the higher price for potatoes, had less money left to buy more expensive foods.  So they had no choice but to buy even more potatoes to try to fill their stomachs!  In other words, the increase in the price of the potato wiped out the savings of the Irish, who then bought even more potatoes despite its increase in price.  Note that the potato could have been a Giffen good only if it was also an “inferior” good that saw a surge in demand when people had less income (less money to spend).

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.<ref>"There is no way to buy more potatoes when there are fewer potatoes. Thus, the Giffen legend concerning the great potato famine appears at best to be a misinterpretation of some observed but misunderstood phenomenon, and at worst a kind of hoax."[http://www.questia.com/googleScholar.qst;jsessionid=KJGB9YyNvyL1pjkp56C2BQfrF2GwvdyxRFYZXlDsgQN3p53LNPrG!766828861!343156199?docId=5000354671]</ref>

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.<ref>"There is no way to buy more potatoes when there are fewer potatoes. Thus, the Giffen legend concerning the great potato famine appears at best to be a misinterpretation of some observed but misunderstood phenomenon, and at worst a kind of hoax."[http://www.questia.com/googleScholar.qst;jsessionid=KJGB9YyNvyL1pjkp56C2BQfrF2GwvdyxRFYZXlDsgQN3p53LNPrG!766828861!343156199?docId=5000354671]</ref>

Giffen goods are exceptions to the Law of Demand ... if Giffen goods really exist!  Many, including your teacher, are skeptical that there really is such a thing as a Giffen good.

Giffen goods are exceptions to the Law of Demand ... if Giffen goods really exist!  Many, including your teacher, are skeptical that there really is such a thing as a Giffen good.

Economist Thorstein Veblen suggested that a "status symbol," like a fancy car or diamond, can have an increase in demand when its price goes up.  While "status symbols" certainly do exist, it is questionable whether the demand for them ever increases due to an increase in price.  If it does occur, then it is a "Veblen good."  Notice that a "Giffen good" is not a status symbol as a Veblen good would be.

Economist Thorstein Veblen suggested that a "status symbol," like a fancy car or diamond, can have an increase in demand when its price goes up.  While "status symbols" certainly do exist, it is questionable whether the demand for them ever increases due to an increase in price.  If it does occur, then it is a "Veblen good."  Notice that a "Giffen good" is not a status symbol as a "Veblen good" would be.

==Utility and Diminishing Marginal Utility==

==Utility and Diminishing Marginal Utility==