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Changes in Income Changes in Income An increase in income will An increase in income will cause the budget constraint cause the budget constraint out in a parallel manner out in a parallel manner Since Since P P X / / P P Y does not change, does not change, the the MRS MRS will stay constant as will stay constant as the worker moves to higher the worker moves to higher levels of satisfaction levels of satisfaction

Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

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Page 1: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Changes in IncomeChanges in Income

An increase in income will cause the An increase in income will cause the budget constraint out in a parallel budget constraint out in a parallel mannermanner

Since Since PPXX//PPYY does not change, the does not change, the MRSMRS

will stay constant as the worker moves will stay constant as the worker moves to higher levels of satisfactionto higher levels of satisfaction

Page 2: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Increase in IncomeIncrease in Income

If both If both XX and and YY increase as income increase as income rises, rises, XX and and YY are are normalnormal goods goods

Quantity of X

Quantity of Y

C

U3

B

U2

A

U1

As income rises, the individual choosesto consume more X and Y

Page 3: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Increase in IncomeIncrease in Income

If If XX decreases as income rises, decreases as income rises, XX is an is an inferiorinferior good good

Quantity of X

Quantity of Y

C

U3

As income rises, the individual choosesto consume less X and more Y

Note that the indifferencecurves do not have to be “oddly” shaped. Theassumption of a diminishing MRS is obeyed.

B

U2

AU1

Page 4: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Engel’s LawEngel’s Law

Using Belgian data from 1857, Engel Using Belgian data from 1857, Engel found an empirical generalization about found an empirical generalization about consumer behaviorconsumer behavior

The proportion of total expenditure The proportion of total expenditure devoted to food declines as income risesdevoted to food declines as income rises food is a necessity whose consumption rises food is a necessity whose consumption rises

less rapidly than incomeless rapidly than income

Page 5: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Substitution & Income EffectsSubstitution & Income EffectsEven if the individual remained on the same Even if the individual remained on the same

indifference curve when the price changes, indifference curve when the price changes, his optimal choice will change because the his optimal choice will change because the MRSMRS must equal the new price ratio must equal the new price ratio the substitution effectthe substitution effect

The price change alters the individual’s The price change alters the individual’s “real” income and therefore he must move “real” income and therefore he must move to a new indifference curveto a new indifference curve the income effectthe income effect

Page 6: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Changes in a Good’s PriceChanges in a Good’s Price

A change in the price of a good alters A change in the price of a good alters the slope of the budget constraintthe slope of the budget constraint it also changes the it also changes the MRSMRS at the consumer’s at the consumer’s

utility-maximizing choicesutility-maximizing choices

When the price changes, two effects When the price changes, two effects come into playcome into playsubstitution effectsubstitution effect income effectincome effect

Page 7: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Changes in a Good’s PriceChanges in a Good’s Price

Quantity of X

Quantity of Y

U1

A

Suppose the consumer is maximizing utility at point A.

U2

B

If the price of good X falls, the consumer will maximize utility at point B.

Total increase in X

Page 8: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Changes in a Good’s PriceChanges in a Good’s Price

U1

U2

Quantity of X

Quantity of Y

A

B

To isolate the substitution effect, we hold“real” income constant but allow the relative price of good X to change

C

Substitution effect

The substitution effect is the movementfrom point A to point C

The individual substitutes good X for good Y because it is now relatively cheaper

Page 9: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Changes in a Good’s PriceChanges in a Good’s Price

U1

U2

Quantity of X

Quantity of Y

A

B

The income effect occurs because theindividual’s “real” income changes whenthe price of good X changes

C

Income effect

The income effect is the movementfrom point C to point B

If X is a normal good,the individual will buy more because “real”income increased

Page 10: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Changes in a Good’s PriceChanges in a Good’s Price

U2

U1

Quantity of X

Quantity of Y

B

A

An increase in the price of good X means thatthe budget constraint gets steeper

CThe substitution effect is the movement from point A to point C

Substitution effect

Income effect

The income effect is the movement from point C to point B

Page 11: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Price Changes forPrice Changes forNormal GoodsNormal Goods

If a good is normal, substitution and If a good is normal, substitution and income effects reinforce one anotherincome effects reinforce one anotherWhen price falls, both effects lead to a rise When price falls, both effects lead to a rise

in Qin QDD

When price rises, both effects lead to a drop When price rises, both effects lead to a drop in Qin QDD

Page 12: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Price Changes forPrice Changes forInferior GoodsInferior Goods

If a good is inferior, substitution and income If a good is inferior, substitution and income effects move in opposite directionseffects move in opposite directions

The combined effect is indeterminateThe combined effect is indeterminateWhen price rises, the substitution effect leads When price rises, the substitution effect leads

to a drop in Qto a drop in QDD, but the income effect leads to a , but the income effect leads to a rise in Qrise in QDD

When price falls, the substitution effect leads to When price falls, the substitution effect leads to a rise in Qa rise in QDD, but the income effect leads to a fall , but the income effect leads to a fall in Qin QDD

Page 13: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Giffen’s ParadoxGiffen’s Paradox

If the income effect of a price change is If the income effect of a price change is strong enough, there could be a positive strong enough, there could be a positive relationship between price and Qrelationship between price and QDD

An increase in price leads to a drop in real An increase in price leads to a drop in real incomeincome

Since the good is inferior, a drop in income Since the good is inferior, a drop in income causes Qcauses QDD to rise to rise

Thus, a rise in price leads to a rise in QThus, a rise in price leads to a rise in QDD

Page 14: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Summary of Income & Summary of Income & Substitution EffectsSubstitution Effects

Utility maximization implies that (for normal Utility maximization implies that (for normal goods) a fall in price leads to an increase in goods) a fall in price leads to an increase in QQDD

The The substitution effectsubstitution effect causes more to be causes more to be purchased as the individual moves along an purchased as the individual moves along an indifference curveindifference curve

The The income effectincome effect causes more to be purchased causes more to be purchased because the resulting rise in purchasing power because the resulting rise in purchasing power allows the individual to move to a higher allows the individual to move to a higher indifference curveindifference curve

Page 15: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Summary of Income & Summary of Income & Substitution EffectsSubstitution Effects

Utility maximization implies that (for normal Utility maximization implies that (for normal goods) a rise in price leads to a decline in Qgoods) a rise in price leads to a decline in QDD

The The substitution effectsubstitution effect causes less to be causes less to be purchased as the individual moves along an purchased as the individual moves along an indifference curveindifference curve

The The income effectincome effect causes less to be purchased causes less to be purchased because the resulting drop in purchasing power because the resulting drop in purchasing power moves the individual to a lower indifference curvemoves the individual to a lower indifference curve

Page 16: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Summary of Income & Summary of Income & Substitution EffectsSubstitution Effects

Utility maximization implies that (for inferior Utility maximization implies that (for inferior goods) no definite prediction can be made goods) no definite prediction can be made for changes in pricefor changes in priceThe The substitution effectsubstitution effect and and income effectincome effect move move

in opposite directionsin opposite directions If the income effect outweighs the substitution If the income effect outweighs the substitution

effect, we have a case of effect, we have a case of Giffen’s paradoxGiffen’s paradox

Page 17: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

The Individual’s Demand CurveThe Individual’s Demand Curve

Quantity of Y

Quantity of X Quantity of X

PX

X2

PX2

U2

X2

I = PX2 + PY

X1

PX1

U1

X1

I = PX1 + PY

X3

PX3

X3

U3

I = PX3 + PY

As the price of X falls...

dX

…quantity of Xdemanded rises.

Page 18: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

The Individual’s Demand CurveThe Individual’s Demand Curve

An An individual demand curveindividual demand curve shows the shows the relationship between the price of a good relationship between the price of a good and the quantity of that good purchased by and the quantity of that good purchased by an individual assuming that all other an individual assuming that all other determinants of demand are held constantdeterminants of demand are held constant

Page 19: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Shifts in the Demand CurveShifts in the Demand Curve

Three factors are held constant when a Three factors are held constant when a demand curve is deriveddemand curve is derived incomeincomeprices of other goodsprices of other goods the individual’s preferencesthe individual’s preferences

If any of these factors change, the If any of these factors change, the demand curve will shift to a new positiondemand curve will shift to a new position

Page 20: Changes in Income An increase in income will cause the budget constraint out in a parallel manner An increase in income will cause the budget constraint

Shifts in the Demand CurveShifts in the Demand Curve

A movement along a given demand A movement along a given demand curve is caused by a change in the price curve is caused by a change in the price of the goodof the goodcalled a called a change in quantity demandedchange in quantity demanded

A shift in the demand curve is caused by A shift in the demand curve is caused by a change in income, prices of other a change in income, prices of other goods, or preferencesgoods, or preferencescalled a called a change in demandchange in demand