demand · 2018-12-05 · measure the level of demand at each price, all we do is add up the total...

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Demand

DemandandSupplyarethetwowordsmostusedineconomicsandforgoodreason.SupplyandDemandaretheforcesthatmakemarketeconomieswork.Theydeterminethequan@tyofeachgoodproducedandthepricethatitissold.Ifyouwanttoknowhowaneventorpolicywillaffecttheeconomy,youmustthinkfirstabouthowitwillaffectsupplyanddemand.

Thisnoteintroducesthetheoryofdemand.LaterwewillseethatwhendemandisjoinedwithSupplytheyformwhatisknownasMarketEquilibrium.MarketEquilibriumdecidesthequan@tyandpriceofeachgoodsoldandinturnweseehowpricesallocatetheeconomy’sscarceresources.

Thequan@tydemandedofanygoodistheamountofthatgoodthatbuyersarewillingandabletopurchase.

Thewordableisveryimportant.Ineconomicswesaythatyouonlydemandsomethingatacertainpriceifyoubuythegoodatthatprice.Ifyouarewillingtopaythepricebeingaskedbutcannotaffordtopaythatprice,thenyoudon’tdemandit.Therefore,whenwearetryingtomeasurethelevelofdemandateachprice,allwedoisaddupthetotalamountthatisboughtateachprice.

Sowhenwearespeakingofdemandineconomicswearereferringtoeffec@vedemand.

Beforewelookfurtherintodemandwemakeourselvesawareofcertaineconomiclawsthathelpexplainconsumer’sbehaviourwhenbuyinggoods.(Rememberwecoveredeconomiclawsintheprevioushandout)

Allnormalgoodsobeythislaw.

Effec0veDemand:referstothedesireforgoodsandservicessupportedbythenecessarypurchasingpower.

LawofDemand:statesthatasthepriceofaproductrisesthequan@tydemandedwillfallandasthepriceofaproductfallssothequan@tydemandedwillrise.

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DemandSchedule

TheDemandCurve

TheDemandSchedule:showsthequan@tydemandedateachprice.

DemandScheduleforIce-CreamCones

Price Quan@ty

€0 12

€0.5 10

€1 8

€1.5 6

€2 4

€2.5 2

€3 0

TheDemandCurve:Thedemandcurve(whichgraphsthedemandschedule)showshowthequan@tydemandedofagoodvariesasitspricevaries.

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Price(€)

Quan@ty0

0 2 4 6 8 10 12

Thereasonaperson’sdemandcurveforanormalgoodslopesdownwardisbecauseasthepriceofagoodfallstheconsumerbuysmoreofthischeapergood,becausethemarginalu@litypercentspentonthisgoodincreasesandtheconsumeraimstomaximisehis/hertotalu@lity.

Thedemandcurveoverleafshow’sanindividual’sdemandforicecreamcones.

However,ifweaddedtogethereachpersonsindividualdemandforanyproduct,wewouldgetwhatiscalledMarketDemand

IndividualDemand:isthequan@tyofagoodanindividualconsumerdemandsatdifferentprices.

MarketDemand:isthetotalquan@tyofagoodthatallconsumersdemandatdifferentprices.

DemandScheduleforIce-CreamCones

Price ConsumerA ConsumerB Market

€5 60 80 140

€10 40 60 100

€15 20 40 60

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604020

ConsumerA’sDemandCurve ConsumerB’sDemandCurve MarketDemandCurve

806040 14010060

DA DB DM

Toderivethemarketdemandaddthequan0tydemandedbyeachindividualconsumerateachpricetocalculatetheoverallquan0ty

demandedbythemarketateachprice.

TheDemandcurveisagraphicalrepresenta@onoftheLAWOFDEMAND.Itshowsthataspricerises,demandfallsandviceversa.Allnormalgoodsobeythislaw.Butsomegoodsbreakthelawofdemandandtheyhavedifferentlyshapeddemandcurves,whichwewilllookatnow.

GoodsthatBreaktheLawofDemand

1) GoodsofOstenta0on(SnobGoods):Somecommodi@esbytheirexclusivenessorexpensivenessareaerac@vetosomebuyers.Ariseinpricemakesthemmoreexclusive,andtherefore,moreaerac@vetothosewiththeincomestopurchasethem.Afallinpricemayleadtoafallinquan@tydemandedastheymaynolongerappearasexclusivetotherichandares@lloutsidethepricerangeofthepoor.Theconsump@onofgoodsofostenta@onisknownasconspicuousconsump@on.

2) GoodsofExpecta0on:Ifprospec@vebuyersthinkthatpricesarelikelytobeevenhigherinthefuture,thecurrentlevelofdemandmaynotfallevenifpricesincreasee.g.ifapersonisconsideringbuyingahousethepossibilitythatpricesarelikelytobeevenhigherinthefuturewillprobablys@mulatedemandatcurrentprices.

3) GoodsofAddic0on:Inthecaseofthosegoodstowhichapersonbecomesaddictede.g.drugs,theynolongeractra@onally.Theybecomesoaddictedtothedrugthatinordertogetthesame'buzz'fromconsump@onofthedrug,demandforthecommoditymayincrease,evenwhenthepriceofthecommodityincreases.

4) GiffenGoods:Forcertainnecessi@esariseinpricecausesanincreaseindemandwhileafallinpricecausesafallindemand.Goodsoflowerqualitymakeupalargepartofthespendingoflowincomefamilies.Asthepricefalls,realincomesincreaseandfamiliesbuylessofthesegoodsandpurchasemore,beeerqualitygoods.Asthepricerisestheyhavelessincometospendonothertypesofgoodssotheytendtoincreasetheirdemandforthesegoods.

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Whenthepriceofanecessitythathasfewsubs@tutesrises,ata@mewhenincomesareextremelylow,thedemandforsuchnecessi@esmayalsorise.Thishappensasconsumerscutoutspendingonmoreexpensiveluxuriesandconsumemoreofthenecessity.

AnIrishexampleofaGiffengoodistheincreaseinthedemandforpotatoesastheirpriceroseduetoscarcityduringtheFamine.PeopleinIrelandspentmuchoftheirincomesonpotatoes(anecessitywithnosubs@tute).Aspotatoesbecamescarceandtheirpricerose,peoplecutoutspendingonothergoodssuchasmeet(aluxury)andallocatedmoremoneytopotatoes.Aspriceincreasedsodiddemand.

I.e.itreferstohowmuchstuffaeurowillbuy.Moreonthatlater.

Seethetableonthefollowingpageforthedemanddecisionoftheconsumerfollowinganincreaseinthepriceofpotatoes.

GiffenGoods:AGiffengoodisanecessitythathasfewsubs@tuteswhichrepresentsalargepor@onoftheexpenditureoflowincomefamilies.GiffengoodsreactabnormallytochangesinrealincomecausedbyapricechangeandassuchbreaktheLawofDemand.

MoneyIncome:Referstoincomeintermsofcurrency.E.g.€500perweek

RealIncome:Therealincomeofaconsumerreferstothepurchasingpowerofmoneyincome.

SpendingofLowIncomeFamilies

ConsumerIncome=€2

TheFamilybuys2goodsonly

Meat=€1.20Potatoes=€0.80

Goods Price Quan@ty Expenditure

Meat 1.2 1 €1.20

Potatoes €0.80 1 €0.80

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Intheaboveexampleweseethateventhoughthepriceofpotatoesrose,thefamilyhadnochoicebuttobuymorepotatoes.Thatmeansthatforthisfamily,potatoesareaGiffenGood.Aspricesrose(theirrealincomefellasthepurchasingpowerofmoneyfell),thefamily’sdemandforpotatoesincreased.

Thereasonforthisunusualbehaviouristhatpotatoesare

1) ANecessity

2) WithFewSubs@tutes

3) Thatrepresentsalargepor@onoftheexpenditureofthislowincomefamily.

Whenyouthinkaboutit,thefamilyreallydidnothaveachoicebuttobuymorepotatoes.YoucanthinkofGiffenGoodsasnecessi@esthatpoorfamilieshavetobuy.Theyhavenochoicebuttobuythesenecessi@es.

SeethenextpagetoviewtheDemandCurveforgoodsthatbreaktheLawofDemand.

Remember,thegoodsthatbreaktheLawofDemandare

1) GoodsofOstenta@on

2) GoodsofExpecta@on

3) GoodsofAddic@on

4) GiffenGoods

SpendingofLowIncomeFamilies

ConsumerIncome=€2

TheFamilybuys2goodsonly

Meat=€1.20Potatoes=€1

Goods Price Quan@ty Expenditure

Meat 1.2 0 €0

Potatoes €1 2 €2

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RegressiveDemandCurves

Sofarwehaveseendemandcurveswhentheyarenotmoving,buttherearemanyfactorswhichcausedemandtochange.Wewillnowhavealookatthefactorswhichcauseachangeindemand.

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Price(€)

Quan@ty

ChangeinDemand

Thefollowingcauseachangeindemand

1) Changeinthepriceofthegooditself

2) PriceofRelatedGoods

3) GovernmentRegula@ons

4) Incomeoftheconsumer

5) ConsumerTastesorPreferences

6) Adver@sing

7) Expecta@onsregardingfutureprice

8) UnplannedFactors

Thefactorscanberepresentedbyademandfunc@on

1) PRICEOFTHEGOODITSELF:Generallyasthepriceofagoodfalls,consumerswillbuymoreofthatgood.Thisisbecauseconsumersaregelngbeeervaluefortheirmoney.Thiscausesadownwardmovementalongtheexis@ngdemandcurve.Asthepriceofagoodrisesconsumerswillbutlessofthatgood.Thisisbecauseconsumersaregelngworsevaluefortheirmoney.Thisincreaseinpricecausesamovementupwardsalongtheexis@ngdemandcurve.NOTE:Thechangeinthepriceofthegooditselfistheonlyfactorthatcausesamovementalongtheexis@ngdemandcurve.Allotherfactorscauseashiminthedemandcurve.

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D = f( , , G, Y, T, A, E, U) P1 P2

MovementUptheDemandCurve MovementDowntheDemandCurvePrice

Quan@ty

2) PRICEOFRELATEDGOODS(Subs0tutesandComplements):Ifthepriceofacomplementarygoodrisesthenthedemandforthegoodinques@on(thisgood)fallsandviceversa.E.g.ifthepriceoftennisracquetsrisesthenthedemandfortennisballswillfall,aspeopletakeupothersports.Thiswillcauseaninwardshiminthedemandcurvefortennisballs.Ifthepriceofsubs@tutegoodrisesthedemandforthegoodinques@onrises.E.g.IfDazwashingpowderrisesinpricetherewillbeanoutwardshiminthedemandforPersil.

E.g.CokeandPepsi/DazandPersiletc.

3) GOVERNMENTREGULATIONS:Ifthegovernmentini@atesaprogramtocurtailconsump@onofapar@cularproductthenitmayaffectthedemandforthisgood.I.e.causinganinwardshiminthedemandcurve.E.g.ahealthcampaigntocurtailcigareeeconsump@on.

4) INCOMEOFTHECONSUMER:Fornormalgoods,asdisposableincomerises,thedemandforthemincreasescausinganoutwardshiminthedemandcurve.Ifincomefalls,thendemandforthesegoodswillfall,resul@nginaninwardshiminthedemandcurve.

5) CONSUMERTASTESORPREFERENCES:whenacommoditycomesintofashionorintoseason,thereisanincreaseinthequan@tydemandedateachprice.I.e.anoutwardshiminthedemandcurve.E.g.thedemandforshortsandt-shirtsrisescominguptosummer.Ahealthscarewillcausedemandtofallresul@nginaninwardshiminthedemandcurve.E.g.salmonellaineggs.

6) ADVERTISING:Asuccessfuladver@singcampaigncausesdemandtoshimoutwards.Areduc@oninadver@singcausesthedemandcurveforagoodtoshiminwards.

7) EXPECTATIONSREGARDINGFUTUREPRICE:Ifaconsumerexpectsthatfuturepricesarelikelytobegreaterinthefuture,thismightcauseanincreaseindemandnowresul@nginanoutwardshiminthe

AMovementAlongtheDemandCurve:iscausedbyachangeinthesellingpriceofthegooditself,allotherthingsbeingequal.

ASUBSTITUTEGOOD:isagoodthatcanfulfillthesamefunc@onasthegoodinques@on.

COMPLEMENTARYGOODS:aregoodsthatareinjointdemand.

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demandcurve.Iffuturepricesareexpectedtofallthenthiswillcauseadecreaseindemandnowresul@nginaninwardshim.

8) UNPLANNEDFACTORS:Iftherewasasuddenheatwavethismightincreasethedemandforice-cream,thuscausinganoutwardshiminthedemandcurveforice-cream.

Frompoint2topoint8above,wehavelookedatthefactorsthatcause“ashiminthedemandcurve”.Remember,achangeinpricecausesamovementandachangeinanyotherfactorcausesashim.

Thereare2differenttypesofshimthatcanhappentoaDemandCurve.AnOutwardShimoranInwardShim.Wewilltakealookatagraphicalrepresenta@onofthemnow.

OutwardshiUintheDemandCurve

ShiUintheDemandCurve:Ifanyofthefactorsotherthanthepriceofthegooditselfchangethiswillresultinashiminthedemandcurve.

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Quan@ty

InwardShiUintheDemandCurve

Whenashiminthedemandcurveoccurs,thequan@tydemandedforthegoodateachpricechanges.Whenthereisaninwardshiminthedemandcurve,thenthequan@tydemandedforthatgoodateachpriceislessamertheshimthanitwasbeforetheshim.Whenthereisanoutwardshiminthedemandcurve,thenthequan@tydemandedforthatgoodateachpriceisgreateramertheshimthanitwasbeforetheshim.

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Quan@ty

NormalGoods,InferiorGoodsandGiffenGoods

RememberNormalgoodsalsorespond“normally”tochangesinrealincome.

I.e.asincomerisesquan@tydemandedrisesandasincomefallsquan@tydemandedfalls.Thisisknownasaposi@veincomeeffect.Normalgoodshaveaposi@veincomeeffect.

Thatistheyrespondabnormallytochangesinrealincome.

I.e.asincomerisesquan@tydemandedfallsandasincomefallsquan@tydemandedrises.

GiffengoodsareinferiorgoodsbecauseallGiffengoodshaveanega@veincomeeffect(whichisthedefini@onofaninferiorgood).ThedifferencebetweenGiffengoodsandordinaryinferiorgoodsisthatGiffengoodsbreakthelawofdemand.

Ifpricesrisethenrealincomefallsandifpricesfallthenrealincomerises(assumingthatmoneyincomeremainsconstant)

Nowthatwehavealltheabovedefini@ons,wewillexplainwhynormalandinferiorgoodsobeythelawofdemandandwhyGiffengoodsbreakthelawofdemand.

FollowingaPricechangetherearetwoseparateeffectsontheconsumer.

1) TheSubs@tu@onEffect

2) TheIncomeEffect

WhenyouaddthesetwoeffectstogetheryougettheoverallPriceEffect.

NormalGoods:aregoodswithaposi@veincomeeffect.Demandforthesegoodsrisesasincomerisesandfallsasincomefalls

InferiorGoods:aregoodswithanega@veincomeeffect.

GiffenGoods:AGiffengoodisanecessitythathasfewsubs@tuteswhichrepresentsalargepor@onoftheexpenditureoflowincomefamilies.GiffengoodsreactabnormallytochangesinrealincomecausedbyapricechangeandassuchbreaktheLawofDemand.

RealIncome:Therealincomeofaconsumerreferstothepurchasingpowerofmoneyincome.

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ThePriceEffectisthetotaleffectondemandfollowingapricechange.Itistheaddi@onoftheIncomeEffectandtheSubs@tu@onEffect.

SUBSTITUTIONEFFECT+INCOMEEFFECT=PRICEEFFECT

TheSubs@tu@oneffectisalwaysposi@veforallgoods-Normal,InferiorandGiffen

Theconsumerwillalwaystendtobuymoreofarela@velycheapergood.ItistheSubs@tu@onEffectthatcausestheconsumertoalwaysbuymoreofarela@velygood.

However,followingapricefall,thegoodisnowrela@velycheaper,theconsumerexperiencesariseinrealincome.Thisistheincomeeffect.

Theincomeeffectcanbeeitherposi@veornega@ve.Normalgoodshaveaposi@veincomeeffectbutInferiorgoodsandGiffenGoodshaveanega@veincomeeffect.Lookattheexampleonthefollowingpage.

Assumeinthecaseofeachofthethreegoodsthatthereisafallinprice.Thenexaminetheeffectsofthispricereduc@ondemand.

THESUBSTITUTIONEFFECT:meansthatasthepriceofagoodfalls,consumerstendtobuymoreofitasthera@oofMarginalU@lity(MU)topriceincreases.Theconsumerwillswitchawayfromothergoodswhicharenowrela@velydearer.

THEINCOMEEFFECT:referstothechangeinconsumer’srealincomefollowingapricechange.I.e.ifpricesriserealincomesfallandifpricesfallrealincomesrise.

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TypeofGoodSubs@tu@on

Effect+ IncomeEffect = PriceEffect

Normal

+ + + = PQ

Inferior

+ > = PQ

Giffen

+ < = PQ

Goods(1)and(2)obeythelawofdemand.Inthecaseofgood(2)whichisinferiortheposi@vesubs@tu@oneffectoutweighsthenega@veincomeeffectandsothegoodhasaposi@vepriceeffect(obeysthelawofdemand,whichisthedefini@onofaposi@vepriceeffect).

However,inthecaseofgood(3)whichisbothinferiorandGiffen,thenega@veincomeeffectisstrongerthantheposi@vesubs@tu@oneffectcausinggood(3)tobreakthelawofdemand.

NOTE:Anega@veincomeeffectwilloccur(followingapricechange)whenaconsumersincreaseinrealincomeismoreimportantthanthefactthatthegoodhasbecomecheaper.Thatmeansthatastheconsumersincomerises,theirdemandforthisgoodfalls.

NowLet’sExplainwhatweareTalkingAbout

Nowthatwehavesomeideaaboutthedefini@ons,wewilltakeaslowerandmoreinvolvedlookateachofthestepsinvolvedinunderstandingtheconceptofconsumerchoice.

Whatwearetryingtodoistofindoutwhatchangeinconsumersbehaviourwilloccurwhenthepriceofagoodchanges.Willconsumersbuymoreorangesandlessappleswhenthepriceoforangesfalls?Willconsumersbuymorecarsandlessbusjourney’swhenthepriceofbusjourney’sfall?Someoftheanswersmightbesurprisingbutifyoufollowthestepsthatareoutlinedbelowyouwillbeabletoseehoweconomiststrytoexplainhowconsumersspendtheirmoneyandchangetheirspendinghabitsamerpriceschange.

Twothingsmustbemen@onedbeforewestart.Firstly,thistopicisverydifficult.InmyopinionitshouldnotbeontheLeavingCertcourseandismoredifficulttounderstandwithoutapriorknowledgeofwhatarecalledindifferencecurves.Toemphasishowdifficultthisstuffis,itisusuallylemun@lsecondyearincollege,itisseenasbeingtoodifficultforfirstyears!!!!!!.Secondly,itrarelycomesupandwhenitdoesitisofarela@velysimplenature.

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Withbothofthosepointsbeingmade,youshouldrealisethatitisquitestraightforwardtounderstandonceyoufollowthestepsthatIwilloutlinebelow,andintheunfortunateeventthatyoucannotunderstandthesesteps,youreallyonlyneedtoknowtheneteffectofapricechangeonthreetypesofgoods(NormalGoods,InferiorGoodsandGiffenGoods).Thesecanbelearnedoffandyieldthesamenumberofmarksifunderstandingthefollowingstepsalludesyou.

StepstofollowwhenAssessingConsumerChoice

Toanswerques@onsontheoverallpriceeffect,askyourselfthefollowingques@ons

1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?

2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?

3) Haveyoubecomericherorpoorerinrealterms?

4) Doesthegoodhaveanega@veorposi@veincomeeffect?

5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?

6) Dotheseeffectsworkinthesamedirec@onoropposite.

7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger

Don’tbeworriedthatyoudon’tunderstandwhatanyofthesethingsmean,justbeawarethatwhenyouarefinishedreadingthenextfewpages,ifyoucannotunderstandthestepsoutlinedabove,thenyouneedtogooverthefollowingpagesagain.

LetsMakeaStart

Ineconomicswehavetwodifferentmeasuresofincome.

1) NominalIncome

2) RealIncome

E.g.€500perweek.Itistheamountofmoneyreceivedperunitof@me.Day,week,month,yearetc.

NominalIncome:Referstoincomeintermsofcurrency.

REALINCOME:Therealincomeofaconsumerreferstothepurchasingpowerofmoneyincome.

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RealIncomedependsontwothings.Theamountofmoneyapersonreceives(theirnominalincome)andthepricesthathehastopayinordertobuygoodsandservices.NominalIncomeonlydependsontheamountofmoneyapersonreceives.

AnExampleofNominalandRealIncome

EXAMPLE1:

Inaverysimpleeconomy,wewillassumethatworkersearn€’sandthereisonlyonegoodproduced.BigMacs.

Aworkerearns€500perweekandthePriceofBigMacsis€5each.

Calculate

1) HisNominalIncome

2) HisRealIncome

Answer

1) HisNominalIncomeis€500

2) Hisrealincomeiscalculatedbydividinghismoneyincomebyprice€500÷€5=100BigMacs

Twothingsthatyoushouldnote.Firstly,nominalincomeisjusttheamountofmoneyreceivedbyaperson(consumer)anditismeasuredineuros.Secondly,RealincomeiscalculatedbydividingNominalIncomebyPriceandismeasuredintermsofunitsofgoodsandservicesaffordable.

EXAMPLE2:

Inaverysimpleeconomy,wewillassumethatworkersearn€’sandthereisonlyonegoodproduced.Milkshakes.

Aworkerearns€1,000perweekandthePriceofMilkshakesis€2each.

Calculate

1) HisNominalIncomeJonathanTraynor

RealIncome =NominalIncome

2) HisRealIncome

Answer

1) HisNominalIncomeis€1,000

2) Hisrealincomeiscalculatedbydividinghismoneyincomebyprice€1,000÷€2=500Milkshakes

Again,NominalIncomeismeasuredineurosandRealIncomeismeasuredinunitsofgoodsandservices.InthiscaseMilkshakes.

MoneyIncomeisonlyaffectedbytheamountofincomeyoureceive.

Ifyougetaraise,yourmoneyincomehasrisen.

Ifyougetawagereduc@on,yourmoneyincomehasfallen.

RealIncomedependsontwothings.

1) MoneyIncome

2) Prices

Ifyourmoneyincomerises(holdingpricesconstant),yourrealincomehasalsoincreased.Ifyourmoneyincomefalls(holdingpricesconstant),yourrealincomehasalsofallen.Ifyourmoneyincomestaysthesame,butpricesincrease,yourrealincomehasfallen.Ifyourmoneyincomestaysthesame,butpricesfall,yourrealincomehasrisen.

MoreExamples

Ineachofthefollowingcaseswelookatwhathappenstoaconsumersrealincome

1) Incomerisesandpricesstaythesame

2) Incomefallsandpricesstaythesame

3) Incomestaysthesameandpricesrise

4) Incomestaysthesameandpricesfall

5) Incomerisesandpricesfall

6) Incomefallsandpricesrise

7) Incomeriseandpricesrise

8) Incomefallsandpricesfall

Thereasonthatwecan’tsaywhathappenstoRealIncomeforthelasttwoisthatwedon‘tknowhowmuchincomeshavechangedandhowmuchpriceshavechanged.IfweknewbothofthesethingsthenwecouldsaywhattheeffectonRealIncomewas.

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RealIncomeRises

RealIncomeFalls

Can’tSay

PriceEffects

FollowingaPricechangetherearetwoseparateeffectsontheconsumer.

1. TheSubs@tu@onEffect

2. TheIncomeEffect

WhenyouaddthesetwoeffectstogetheryougettheoverallPriceEffect.

ThePriceEffectisthetotaleffectondemandfollowingapricechange.Itistheaddi@onoftheIncomeEffectandtheSubs@tu@onEffect.

SUBSTITUTIONEFFECT+INCOMEEFFECT=PRICEEFFECT

TotrytoputthisinEnglish,allwearesayingisthatwhenthepriceofagoodchangesaconsumerhastomakeadecisiononhowtobestspendhismoneyinordertomaximisehisu@litywiththenewprices.Thelawofdemandsaysthatasthepricerises,consumersbuylessofagood.Thisistruebutinordertomaximisetheiru@lity,consumersmustspendalltheirmoney.

Therefore,ifconsumersbuylessofacertaingood,theys@llmighthavesomemoneylemandassuchmightbuymoreofothergoods.Soconsumersmightbuylessofthegoodwho’spricehasrisenbuttheymightalsobuymoreofothergoodswho’spricehasremainedthesame.

Thesubs@tu@oneffectisonewaythattheconsumersviewsthepricechange.Allitsaysisthatconsumerstendtobuymoreofarela0velycheapergood.

Theincomeeffectisanotherwaythattheconsumercanviewthepricechange.Theincomeeffectismorecomplexandassuchwewillwaitun@llatertodiscussit.

Iftheincomeeffectandthesubs@tu@onbothtelltheconsumertobuymoreofagoodasthepriceofthisgoodfalls(asinthecaseofanormalgood),thenthat’swhattheywilldo.

Ifthesubs@tu@oneffecttellstheconsumertobuymoreofthegoodasitspricefallsandtheincomeeffecttellstheconsumertobuylessofthe

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goodasthepriceofthegoodfalls,thenitisliketheconsumeristornbetweenwhatac@ontotake.Ifthesubs@tu@oneffectisstrongerthantheincomeeffect,thentheconsumerwillbuymoreofthegoodasthepriceofthegoodfalls.Iftheincomeeffectisstrongerthanthesubs@tu@oneffect,thantheconsumerwillbuylessofthegoodasthepriceofthegoodfallsandchoosetobuyothergoodsinstead.

Wewilllookateachoftheseeffectsinturnstar@ngwiththesubs@tu@oneffect.

Subs0tu0onEffect

Allthesubs@tu@oneffectsmeansisthatconsumerswillbuymoreofrela@velycheapergoods.

TheSubs@tu@oneffectisalwaysposi@veforallgoods-Normal,InferiorandGiffen

Theconsumerwillalwaystendtobuymoreofarela@velycheapergood.ItistheSubs@tu@onEffectthatcausestheconsumertoalwaysbuymoreofarela@velycheapergood.

EXAMPLE

Wehavetwogoods,PepsiandPizza.ThepriceofPepsirises.

1) Whichgoodhasbecomerela@velycheaper

2) Whichgoodhasbecomerela@velydearer

3) Whatthesubs@tu@oneffectsayswillhappentothedemandforeachgood.

ANSWER

1) ThePizzahasbecomerela@velycheaper.Eventhoughthepriceofthepizzahasnotchanged,thepriceofpepsihasincreasedandassuchpizzahasbecomeRELATIVELYCHEAPERcomparedtopepsi.

2) Thepepsihasbecomerela@velydearer.Thisisbecausethepriceofpepsihasrisenandthepriceofpizzahasstayedthesame.

3) Thesubs@tu@oneffectsaysthatconsumerswillnowbuylesspepsiandnowbuymorepizza.

THESUBSTITUTIONEFFECT:meansthatasthepriceofagoodfalls,consumerstendtobuymoreofitasthera@oofMarginalU@lity(MU)topriceincreases.Theconsumerwillswitchawayfromothergoodswhicharenowrela@velydearer.

JonathanTraynor

Inordertoansweranyques@ononconsumerbehaviour,youmusttakeintoaccountboththesubs@tu@oneffectandincomeeffect.Thesubs@tu@oneffectiseasy,itjustmeansyoubuymoreofrela@velycheapergoods.Asthepriceofagoodfalls,thesubs@tu@oneffecttellsyoutobuymore.Asthepriceofagoodrises,thesubs@tu@oneffecttellsyoutobuyless.

Theincomeeffectdependsonthetypeofgoodinques@on.Thatiswhatwewillturnouraeen@ontonow.

IncomeEffect

FollowingachangeinPrice,theconsumerexperiencesachangeinrealincome.Thisistheincomeeffect

Theincomeeffectcanbeeitherposi@veornega@ve.

Whatdoesitmeanifagoodhasaposi@veincomeeffect?

Itmeansthatconsumerswillbuymoreofagoodastheirrealincomerises.

Normalgoodshaveaposi@veincomeeffect.

WhatisaNormalGood?

Itisagoodthathasaposi@veincomeeffect.Aposi@veincomeeffectmeansthatyoubuymoreofthegoodasyourrealincomerisesandlessofthegoodasyourrealincomefalls

Whatdoesitmeanifagoodhasanega@veincomeeffect.

Itmeansthatyouhaveatendencytobuylessofthegoodasyourrealincomerises.

InferiorgoodsandGiffenGoodshaveanega@veincomeeffect.

Whatisaninferiorgood?

Itisagoodwithanega@veincomeeffect.Thismeansthatyoubuylessofthegoodasyourrealincomerisesandmoreofthegoodasyourrealincomefalls

THEINCOMEEFFECT:referstothechangeinconsumer’srealincomefollowingapricechange.I.e.ifpricesriserealincomesfallandifpricesfallrealincomesrise.

JonathanTraynor

ExamplesofIncomeEffectforNormalGoods

ForaNormalgood,anincreaseinrealincomewouldcauseanincreaseindemandforthegood.

Ineachofthefollowingcasesstatewhathappenstorealincomeandthenstatehowtheincomeeffectwouldaffectdemand.

1) ARiseinthepriceofPepsi

AsthepriceofPepsihasrisen,thismeansthattheconsumersrealincomehasfallen.TheconsumercannowaffordlessPepsi,andassuchispoorerinrealterms.

AsPepsiisaNormalGoodandyoubuylessnormalgoodsasyourrealincomefalls,theincomeeffectwouldbetobuylessPepsi.

2) AFallinthepriceofFosse]ssweets.

AsthepriceofFosseessweetshasfallen,thismeansthattheconsumersrealincomehasrisen.TheconsumercannowaffordmoreFosseessweets,andassuchisricherinrealterms.

AsFosseessweetsareanormalgoodandyoubuymorenormalgoodsasyourealincomerises,theincomeeffectwouldbetobuymoreFosseessweets.

3) AFallinthepriceofcars

Asthepriceofcarshasfallen,thismeansthattheconsumersrealincomehasrisen.Theconsumercannowaffordmorecars,andassuchisricherinrealterms.

Ascarsareanormalgoodandyoubuymorenormalgoodsasyourealincomerises,theincomeeffectwouldbetobuymorecars.

4) ARiseinthepriceofT.V.

AsthepriceofT.V.’shaverisen,thismeansthattheconsumersrealincomehasfallen.TheconsumercannowaffordlessT.V.’s,andassuchispoorerinrealterms.

AsT.V.’sareaNormalGoodandyoubuylessnormalgoodsasyourrealincomefalls,theincomeeffectwouldbetobuylessT.V.’s.

5) ARiseinthepriceofInsurance

AsthepriceofInsurancehasrisen,thismeansthattheconsumersrealincomehasfallen.Theconsumercannowaffordlessinsurance,andassuchispoorerinrealterms.

JonathanTraynor

AsinsuranceisaNormalGoodandyoubuylessnormalgoodsasyourrealincomefalls,theincomeeffectwouldbetobuylessinsurance.

ExamplesofIncomeEffectforInferiorGoods

Foraninferiorgood,anincreaseinrealincomecausesafallinthedemandforthegood.

Ineachofthefollowingcasesstatewhathappenstorealincomeandthenstatehowtheincomeeffectwouldaffectdemand.

1) ARiseinthePriceofPotatoes

AsthepriceofPotatoeshasrisen,thismeansthattheconsumersrealincomehasfallen.TheconsumercannowaffordlessPotatoes,andassuchispoorerinrealterms.

Aspotatoesareaninferiorgoodandyoubuymoreofaninferiorgoodasyourrealincomefalls,theincomeeffectwouldbetobuymorepotatoes.

2) AFallinthePriceofRice.

Asthepriceofricehasfallen,thismeansthattheconsumersrealincomehasrisen.Theconsumercannowaffordmorerice,andassuchisricherinrealterms.

Asriceisaninferiorgoodandyoubuylessofaninferiorgoodasyourrealincomerises,theincomeeffectwouldbetobuylessrice.

3) AFallinthePriceofBusJourney’s

Asthepriceofbusjourney’shasfallen,thismeansthattheconsumersrealincomehasrisen.Theconsumercannowaffordmorebusjourney’s,andassuchisricherinrealterms.

Asbusjourney’sareaninferiorgoodandyoubuylessofaninferiorgoodasyourrealincomerises,theincomeeffectwouldbetobuylessbusjourney’s.

4) ARiseinthePriceofmincedmeat

Asthepriceofmincedmeathasrisen,thismeansthattheconsumersrealincomehasfallen.Theconsumercannowaffordlessmincedmeat,andassuchispoorerinrealterms.

JonathanTraynor

Asmincedmeatisaninferiorgoodandyoubuymoreofaninferiorgoodasyourrealincomefalls,theincomeeffectwouldbetobuymoremincedmeat.

Wehavelookedatboththesubs@tu@oneffectandtheincomeeffectseparately.Inordertofindouthowmuchaconsumerwillincreaseordecreasethequan@tyofagoodthattheybuyfollowingapricechange,wemustcombinethesetwoeffects.

Inordertocombinethesetwoeffects,wegobacktothestepsthatwediscussedonpage16ofthisnotewhichhavebeenrepeatedonthenextpage.

StepstofollowwhenAssessingConsumerChoice

Toanswerques@onsontheoverallpriceeffect,askyourselfthefollowingques@ons

7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger

EXAMPLE

Explainhowindividuallythe

• Subs@tu@onEffect

• IncomeEffect

combinetogivetheoverallpriceeffectoneachofthefollowinggoods.

a) ThepriceofpepsifallsNormalGood

b) ThepriceofcarsriseNormalGood

JonathanTraynor

c) Thepriceofbusjourney’sriseInferiorGood

d) Thepriceofbusjourney’sfallsInferiorGood

e) ThepriceofpotatoesfallGiffenGood

f) ThepriceofricerisesGiffenGood

AnswertoQues0on(a)

Asthepriceofthegoodhasfallen,thegoodhasbecomerela@velycheaper

Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velycheaper,thesubs@tu@oneffectsaysthatyouwillbuymoreofthisgood.

AstheGoodhasbecomerela@velycheaper,theconsumerisricherinrealtermsastheycanaffordtobuymoreofthegood.

Pepsiisanormalgoodandassuchhasaposi@veincomeeffect.

AsPepsiisanormalgoodwithaposi@veincomeeffect,thathasbecomecheaperinrealterms,theincomeeffectsaysthatyouwillbuymoreofthisgood.

Thesubs@tu@oneffectsaysbuymoreasithasbecomerela@velycheaperandtheincomeeffectsaysbuymoreasyouhavebecomericherinrealterms.Therefore,asthepricefallsyoubuymorepepsi.

Answertoques0on(b)

Asthepriceofthegoodhasrisen,thegoodhasbecomerela@velymoreexpensive

JonathanTraynor

Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velydearer,thesubs@tu@oneffectsaysthatyouwillbuylessofthisgood.

AstheGoodhasbecomerela@velydearer,theconsumerispoorerinrealtermsastheycanaffordtobuylessofthegood.

Carsareanormalgoodandassuchhasaposi@veincomeeffect.

Ascarsareanormalgoodwithaposi@veincomeeffect,thathasbecomedearerinrealterms,theincomeeffectsaysthatyouwillbuylessofthisgood.

Thesubs@tu@oneffectsaysbuylessasithasbecomerela@velydearerandtheincomeeffectsaysbuylessasyouhavebecomepoorerinrealterms.Therefore,asthepricerisesyoubuyfewercars.

AnswertoQues0on(c)

Asthepriceofthegoodhasrisen,thegoodhasbecomerela@velymoreexpensive

JonathanTraynor

BusJourney’sareaninferiorgoodandassuchhasanega@veincomeeffect.

AsBusJourney’sareaninferiorgoodwithanega@veincomeeffect,thathasbecomedearerinrealterms,theincomeeffectsaysthatyouwillbuymoreofthisgood.

Thesubs@tu@oneffectsaysbuylessasithasbecomerela@velydearerandtheincomeeffectsaysbuymoreasyouhavebecomepoorerinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.

7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger?

Therearetwopossibleop@ons.Eitherthesubs@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuyslessbusjourneys.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuysmorebusjourneys.Aswehavebeentoldintheques@onthatbusjourney’sareaninferiorgood,weknowthatthesubs@tu@oneffectisalwaysstrongerthantheincomeeffect(thatisonedefini@onofaninferiorgood).ForanInferiorGood,thesubs@tu@oneffectisalwaysstrongerthantheincomeeffect.Therefore,asthepriceofbusjourneysrise,peoplewillbuylessbusjourneysastheposi@vesubs@tu@oneffectisstrongerthanthenega@veincomeeffect.

AnswertoQues0on(d)

Asthepriceofthegoodhasfallen,thegoodhasbecomerela@velycheaper.

JonathanTraynor

BusJourney’sareaninferiorgoodandassuchhasanega@veincomeeffect.

AsBusJourney’sareaninferiorgoodwithanega@veincomeeffect,thathasbecomecheaperinrealterms,theincomeeffectsaysthatyouwillbuylessofthisgood.

Thesubs@tu@oneffectsaysbuymoreasithasbecomerela@velycheaperandtheincomeeffectsaysbuylessasyouhavebecomericherinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.

Therearetwopossibleop@ons.Eitherthesubs@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuysmorebusjourneys.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuyslessbusjourneys.Aswehavebeentoldintheques@onthatbusjourney’sareaninferiorgood,weknowthatthesubs@tu@oneffectisalwaysstrongerthantheincomeeffect(thatisonedefini@onofaninferiorgood).ForanInferiorGood,thesubs@tu@oneffectisalwaysstrongerthantheincomeeffect.Therefore,asthepriceofbusjourneysfall,peoplewillbuymorebusjourneysastheposi@vesubs@tu@oneffectisstrongerthanthenega@veincomeeffect.

AnswertoQues0on(e)

Asthepriceofthegoodhasfallen,thegoodhasbecomerela@velycheaper.

JonathanTraynor

Potatoesareagiffengoodandassuchhasanega@veincomeeffect.

AsPotatoesareagiffengoodwithanega@veincomeeffect,thathasbecomecheaperinrealterms,theincomeeffectsaysthatyouwillbuylessofthisgood.

Thesubs@tu@oneffectsaysbuymoreasithasbecomerela@velycheaperandtheincomeeffectsaysbuylessasyouhavebecomericherinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.

Therearetwopossibleop@ons.Eitherthesubs@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuysmorepotatoes.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuyslesspotatoes.Wehavebeentoldintheques@onthatpotatoesareagiffengood,weknowthattheincomeeffectisalwaysstrongerthanthesubs@tu@oneffect(thatisonedefini@onofangiffengood).ForaGiffenGood,theincomeeffectisalwaysstrongerthanthesubs@tu@oneffect.Therefore,asthepriceofpotatoesfall,peoplewillbuylesspotatoesastheposi@vesubs@tu@oneffectisweakerthanthenega@veincomeeffect.

AnswertoQues0on(f)

Asthepriceofthegoodhasrisen,thegoodhasbecomerela@velydearer.

JonathanTraynor

Riceisagiffengoodandassuchhasanega@veincomeeffect.

Asriceisagiffengoodwithanega@veincomeeffect,thathasbecomedearerinrealterms,theincomeeffectsaysthatyouwillbuymoreofthisgood.

Thesubs@tu@oneffectsaysbuylessasithasbecomerela@velydearerandtheincomeeffectsaysbuymoreasyouhavebecomepoorerinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.

Therearetwopossibleop@ons.Eitherthesubs@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuyslessrice.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuysmorerice.Wehavebeentoldintheques@onthatriceisagiffengood,weknowthattheincomeeffectisalwaysstrongerthanthesubs@tu@oneffect(thatisonedefini@onofangiffengood).ForaGiffenGood,theincomeeffectisalwaysstrongerthanthesubs@tu@oneffect.Therefore,asthepriceofricerises,peoplewillbuymorepotatoesastheposi@vesubs@tu@oneffectisweakerthanthenega@veincomeeffect.

Summary

JonathanTraynor

TypeofGoodSubs@tu@on

Effect+ IncomeEffect = PriceEffect

Normal

+ + + = PQ

Normal

+ + + = PQ

Inferior

+ > - = PQ

Inferior

+ > - = PQ

Giffen

+ < - = PQ

Giffen

+ < - = PQ

demand · 2018-12-05 · measure the level of demand at each price, all we do is add up the total...

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