Ec250 Notes: Day 11

    In practice, a price change generally affects you 2 ways:
    (1) It changes your optimal MRS --> the substitution effect
    (2) It changes your utility --> the income effect
    Both changes affect consumption choices

Learning objectives: Illustrate and explain the substitution effect and income effect of a price change.

    A price change affects quantity demanded because of....
    (1) The substitution effect: the consumption adjustment you make because the new price changes the relative attractiveness of the goods you buy.
    a-->a' shows this: move to the new relative price on your original indifference curve
    Ex: Health food and junk food: A lower relative price (of health food=goodX) makes you tend to substitute health food for junk food (goodY).
    Makes the new BL flatter than before, so you move to a flatter part of any indifference curve you might be on

    (2) The income effect: the consumption adjustment you make because the new price changes your attainable level of well-being.
    a'-->b shows this: you move to your new indifference curve at the new price
    For example, when price falls, the increase in your utility prompts you to change your consumption of health food.

    ? True or false: When the price of a good falls
    (1) The substitution effect always tends to increase consumption of it.
    (2) The income effect always tends to increase consumption of it.

Key results: The substitution effect always makes us consume more of a good when it gets cheaper and less of it when it gets more expensive. It's the pure version of the 'law of demand'.
The income effect of a lower price makes consumption rise for a normal good but fall for an inferior good.

Substitution effect: large when good substitutes are available.
string beans and lima beans

Income effect: large when the budget share of the product is high.
housing, staple foods for the poor

Good counterexample: salt
No good substitute and a small budget share. Both effects are small, so demand for salt is very inelastic.

Failure to separate substitution and income effects can lead to some counterintuitive results.

    Example: rice in Hunan.
    C1: Households are poor enough that they face subsistence nutrition concerns.
    C2: Households consume a very simple diet, including a basic (staple) and a fancy good.
    C3: The basic good is the cheapest source of calories available, comprises a large part of the diet/budget, and has no ready substitute.
    C4: Households cannot be so impoverished that they consume only the staple good.

    Rice = 64% of calorie intake
    The fancy good was meat
    e if at least 20% of calories from non-rice = +0.45.

    So, how did this happen? See worksheet
    (available online: Substitution and income effects: alternative possibilities)

    The substitution effect always makes quantity demanded rise when price falls and vice versa.
    But the market demand curve includes both substitution and income effects.
        For a normal good, the substitution and income effects reinforce each other => D will slope down

? True or false: All Giffen goods are inferior goods, but not all inferior goods are Giffen goods.

    Recap: Necessary conditions for a Giffen good:
    1. Inferior good
    2. Income effect larger than substitution effect

    Recall, cross-price elasticities tell us whether goods are substitutes or complements.
    We know in fact that the distinction shows up in the shape of indifference curves, but in practice, when the price of one good changes, we don't stay on a single indifference curve.
     This can cause income and substitution effect problems.

Ex: Marie Antoinette (+Pbread: "Let them eat cake.")
(example (Java))

? Did Marie Antoinette consider bread and cake to be substitutes or complements?

?How did you decide?

    Let:
    X = Bread (B)
   Y = Cake (C)
and start with a relatively low price of bread.

Let the price of bread rise, and consider first the substitution effect.
? What do we do to show it?

But as utility falls due to the higher price of bread, consumers will move back down their income consumption curve to reach BLb, and the income effect will make cake consumption fall if cake is a normal good.

    Overall:
    1 = substitution effect--raises cake consumption.
    2 = income effect, lowers cake consumption.
    Combined: cake consumption can fall as the price of bread rises.

	Normal good	Inferior good
Substitution effect:
Income effect:
Combined effects: