Individual and Market DemandChapter OutlineSlide 3Slide 4Slide 5Slide 6Slide 7Income and Substitution EffectsIncome and Substitution Effects: Normal GoodIncome and Substitution Effects: Inferior GoodGiffen GoodsSlide 12Individual and Market DemandChapter 4Chapter OutlineIndividual DemandIncome and Substitution EffectsMarket DemandConsumer SurplusEffect of Price ChangesA reduction in the price of food, with income and the price of clothing fixed, causes this consumer to choose a different market basket. In (a), the baskets that maximize utility for various prices of food (point A, $2; B, $1; D, $0.50) trace out the price-consumption curve. Part (b) gives the demand curve, which relates the price of food to the quantity demanded. (Points E, G, and H correspond to points A, B, and D, respectively).Individual DemandEffect of Income ChangesAn increase in income, with the prices of all goods fixed, causes consumers to alter their choice of market baskets. In part (a), the baskets that maximize consumer satisfaction for various incomes (point A, $10; B, $20; D, $30) trace out the income-consumption curve. The shift to the right of the demand curve in response to the increases in income is shown in part (b). (Points E, G, and H correspond to points A, B, and D, respectively.)Individual DemandAn increase in a person’s income can lead to less consumption of one of the two goods being purchased. Here, hamburger, though a normal good between A and B, becomes an inferior good when the income-consumption curve bends backward between B and C.Normal versus Inferior GoodsEngel curves relate the quantity of a good consumed to income. In (a), food is a normal good and the Engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month.Engel CurvesEngel Curves for U.S. ConsumersAverage per-household expenditures on rented dwellings, health care, and entertainment are plotted as functions of annual income. Health care and entertainment are normal goods, as expenditures increase with income.Rental housing, however, is an inferior good for incomes above $35,000.Consumer Expenditures in the United StatesIncome and Substitution EffectsSubstitution effect: that component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods.Income effect: that component of the total effect of a price change that results from the associated change in real purchasing power.Total effect: the sum of the substitution and income effects.decrease in price of food:The substitution effect F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Food is a normal good because the income effect EF2 is positive.Income and Substitution Effects: Normal Gooddecrease in price of food:The resulting change in food purchased can be broken down into a substitution effect, F1E (associated with a move from A to D), and an income effect, EF2 (associated with a move from D to B). In this case, food is an inferior good because the income effect is negative. However, because the substitution effect exceeds the income effect, the decrease in the price of food leads to an increase in the quantity of food demanded.Income and Substitution Effects: Inferior GoodGiffen GoodsGiffen good: one for which the quantity demanded rises as its price rises.The Giffen good must be an inferior good Income effect must dominate substitution effectThe good must occupy a large share of the consumer’s budget (increase in its price should make consumer significantly poorer)Example: Irish potato famine of 19th centuryUpward-Sloping Demand Curve: The Giffen GoodThe consumer is initially at point A, but, after the price of food falls, moves to B and consumes less food. Because the income effect EF2 is larger than the substitution effect F1E, the decrease in the price of food leads to a lower quantity of food demanded.Income and Substitution