A Effects of changes in income on consumption choice

1
(A) Effects of changes in income on consumption
choice

• Normal good A good that you consume more of when
  your income rises given a fixed price.
• E.g.

• Inferior good A good that you consume less of
  when your income rises given a fixed price.
• E.g.

2
Graphical analysis

• Normal good

• Inferior good

beer
beer
pizza
pizza
3
The Engel Curve

• An Engel curve is a curve showing, for fixed
  prices, the relationship between income and the
  quantity of a good consumed.

• Inferior good

• Normal good

beer
beer
pizza
pizza
4
(B) Effects of a change in price on consumption

• Giffen good A good that violates the law of
  demand, so that the price goes up, the quantity
  demanded goes up.
• E.g. sweet potato during the WWII

• Non-Giffen good A good that obeys the law of
  demand When the price goes up, the quantity
  demanded goes down.
• E.g.

5
Graphical Analysis of Giffen Good

• We say sweet potatoes are Giffen goods if price
  of Sweet Potato increases (the black budget line
  changes to the red budget line) but the
  consumption of Y increases (from qy to qy) as
  well while price of X and income are fixed.

Sweet Potato
The optimum consumption point changes from A to B.
qy
B
A
qy
Beef
6
A rise in price generates two effects (I)

• Suppose that rice is a normal good.
• An increase in price of rice generates two
  effects
• Substitution effect eat less of rice, and
  consume more of other food.
• Income effect your income decreases in terms of
  rice. As such, you are effectively poorer and
  thus eat less of rice.
• Combining these two effects the consumption of
  rice (normal good) must decrease, when price
  increases.
• I.e. satisfy the Law of Demand.

7
A rise in price generates two effects (II)

• Suppose that rice is an inferior good.
• An increase in price of rice generates two
  effects
• Substitution effect eat less of rice, and
  consume more of other food.
• Income effect your income decreases in terms of
  rice. As such, you are effectively poorer and
  thus eat more of rice.
• Combine these two effects
• If the income effect exceeds the substitution
  effect, you eat more of rice. This scenario
  violates the Law of Demand!
• If the income effect is weaker than the
  substitution effect, you eat less of rice. The
  Law of Demand still holds.

8
Note

• Inferior goods can be either Giffen or
  non-Giffen.
• Giffen goods must be inferior and thus not normal.

All possible consumption goods
Inferior goods
Normal goods
Giffen
9
Graphical Analysis of Income and Substitution
Effects (Exhibit 4.9)
All Other goods
All Other goods
C
B
A
B
A
8
3
Candy Bars
5
8
3
Candy Bars
Price
Here, candy bars are normal good. The implied
demand curve is downward sloping.
B
New price
Original price
A
5
8
3
Candy Bars
10
Graphical Analysis of Income and Substitution
Effects (Exhibit 4.11)
All Other goods
All Other goods
C
A
A
B
B
6
8
Candy Bars
8
6
4
Candy Bars
Price
In this exhibit, X is inferior good but not
Giffen. The implied demand curve is still
downward sloping.
B
New price
Original pirce
A
If X is Giffen, the demand curve will be upward
sloping.
6
4
8
Candy Bars
11
Example (inferior goods)

• Mary only consumes beers and eggs. Beers are
  inferior goods for her. One day the price of
  eggs goes up. Mary will
• buy more beers
• buy less beers
• buy as many as before
• Ans a
• Q is it possible that eggs are
• inferior too?

eggs
beer
12
Example (inferior goods)

• When the price of shoes goes up, Tara goes right
  on buying just as many shoes as before. True or
  false Shoes could not possibly be an inferior
  good for Tara.
• Note If not specified, we lump together all the
  other stuffs that are not shoes (in this case)
  and measure it as a single unit like dollars --
  the composite-good convention.

• Ans False. Shoes must be inferior in this case.

All the other goods
shoes
13
Example (inferior vs Giffen)

• Mike consumes only beer and rice. When the price
  of beer rises, he responds by eating less rice.
• Is rice an inferior good for Mike?
• Is rice an Giffen good for Mike?

• Ans Rice must be normal (thus cannot be inferior
  or Giffen).

Rice
Beer
14
Example

• Your income is 500 a month, you sign up a
  telephone plan that costs 40 per month plus 5
  cents per call.
• Suppose that the phone company offers an
  alternative plan that costs 60 per month plus 2
  cents per call. You like this plan better so you
  switch after switching, you make fewer calls per
  month.

• Are phone calls inferior?

All the other goods
Calls