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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Quan@ty0
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0.5
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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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15
10
5
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ConsumerA’sDemandCurve ConsumerB’sDemandCurve MarketDemandCurve
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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
€2
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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
€2
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RegressiveDemandCurves
Sofarwehaveseendemandcurveswhentheyarenotmoving,buttherearemanyfactorswhichcausedemandtochange.Wewillnowhavealookatthefactorswhichcauseachangeindemand.
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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
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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:[email protected]@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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InwardShiUintheDemandCurve
Whenashiminthedemandcurveoccurs,thequan@tydemandedforthegoodateachpricechanges.Whenthereisaninwardshiminthedemandcurve,thenthequan@tydemandedforthatgoodateachpriceislessamertheshimthanitwasbeforetheshim.Whenthereisanoutwardshiminthedemandcurve,thenthequan@tydemandedforthatgoodateachpriceisgreateramertheshimthanitwasbeforetheshim.
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Price
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D2
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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@[email protected]@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
(1)
Normal
Goods
+ + + = PQ
(2)
Inferior
Goods
+ > = PQ
(3)
Giffen
Goods
+ < = PQ
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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.
[email protected],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.€[email protected],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
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RealIncome =NominalIncome
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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
RealIncomeRises
RealIncomeRises
RealIncomeFalls
RealIncomeFalls
RealIncomeFalls
Can’tSay
Can’tSay
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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,[email protected]@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.
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Inordertoansweranyques@ononconsumerbehaviour,youmusttakeintoaccountboththesubs@[email protected]@tu@oneffectiseasy,itjustmeansyoubuymoreofrela@velycheapergoods.Asthepriceofagoodfalls,thesubs@[email protected],thesubs@tu@oneffecttellsyoutobuyless.
Theincomeeffectdependsonthetypeofgoodinques@on.Thatiswhatwewillturnouraeen@ontonow.
IncomeEffect
FollowingachangeinPrice,theconsumerexperiencesachangeinrealincome.Thisistheincomeeffect
Theincomeeffectcanbeeitherposi@veornega@ve.
Whatdoesitmeanifagoodhasaposi@veincomeeffect?
Itmeansthatconsumerswillbuymoreofagoodastheirrealincomerises.
Normalgoodshaveaposi@veincomeeffect.
WhatisaNormalGood?
[email protected]@veincomeeffectmeansthatyoubuymoreofthegoodasyourrealincomerisesandlessofthegoodasyourrealincomefalls
Whatdoesitmeanifagoodhasanega@veincomeeffect.
Itmeansthatyouhaveatendencytobuylessofthegoodasyourrealincomerises.
InferiorgoodsandGiffenGoodshaveanega@veincomeeffect.
Whatisaninferiorgood?
Itisagoodwithanega@veincomeeffect.Thismeansthatyoubuylessofthegoodasyourrealincomerisesandmoreofthegoodasyourrealincomefalls
THEINCOMEEFFECT:referstothechangeinconsumer’srealincomefollowingapricechange.I.e.ifpricesriserealincomesfallandifpricesfallrealincomesrise.
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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.
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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.
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Asmincedmeatisaninferiorgoodandyoubuymoreofaninferiorgoodasyourrealincomefalls,theincomeeffectwouldbetobuymoremincedmeat.
Wehavelookedatboththesubs@tu@oneffectandtheincomeeffectseparately.Inordertofindouthowmuchaconsumerwillincreaseordecreasethequan@tyofagoodthattheybuyfollowingapricechange,wemustcombinethesetwoeffects.
Inordertocombinethesetwoeffects,wegobacktothestepsthatwediscussedonpage16ofthisnotewhichhavebeenrepeatedonthenextpage.
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
EXAMPLE
Explainhowindividuallythe
• Subs@tu@onEffect
• IncomeEffect
combinetogivetheoverallpriceeffectoneachofthefollowinggoods.
a) ThepriceofpepsifallsNormalGood
b) ThepriceofcarsriseNormalGood
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c) Thepriceofbusjourney’sriseInferiorGood
d) Thepriceofbusjourney’sfallsInferiorGood
e) ThepriceofpotatoesfallGiffenGood
f) ThepriceofricerisesGiffenGood
AnswertoQues0on(a)
1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?
Asthepriceofthegoodhasfallen,thegoodhasbecomerela@velycheaper
2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?
Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velycheaper,thesubs@tu@oneffectsaysthatyouwillbuymoreofthisgood.
3) Haveyoubecomericherorpoorerinrealterms?
AstheGoodhasbecomerela@velycheaper,theconsumerisricherinrealtermsastheycanaffordtobuymoreofthegood.
4) Doesthegoodhaveanega@veorposi@veincomeeffect?
Pepsiisanormalgoodandassuchhasaposi@veincomeeffect.
5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?
AsPepsiisanormalgoodwithaposi@veincomeeffect,thathasbecomecheaperinrealterms,theincomeeffectsaysthatyouwillbuymoreofthisgood.
6) Dotheseeffectsworkinthesamedirec@onoropposite.
Thesubs@tu@oneffectsaysbuymoreasithasbecomerela@velycheaperandtheincomeeffectsaysbuymoreasyouhavebecomericherinrealterms.Therefore,asthepricefallsyoubuymorepepsi.
Answertoques0on(b)
1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?
Asthepriceofthegoodhasrisen,thegoodhasbecomerela@velymoreexpensive
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2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?
Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velydearer,thesubs@tu@oneffectsaysthatyouwillbuylessofthisgood.
3) Haveyoubecomericherorpoorerinrealterms?
AstheGoodhasbecomerela@velydearer,theconsumerispoorerinrealtermsastheycanaffordtobuylessofthegood.
4) Doesthegoodhaveanega@veorposi@veincomeeffect?
Carsareanormalgoodandassuchhasaposi@veincomeeffect.
5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?
Ascarsareanormalgoodwithaposi@veincomeeffect,thathasbecomedearerinrealterms,theincomeeffectsaysthatyouwillbuylessofthisgood.
6) Dotheseeffectsworkinthesamedirec@onoropposite.
Thesubs@tu@oneffectsaysbuylessasithasbecomerela@velydearerandtheincomeeffectsaysbuylessasyouhavebecomepoorerinrealterms.Therefore,asthepricerisesyoubuyfewercars.
AnswertoQues0on(c)
1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?
Asthepriceofthegoodhasrisen,thegoodhasbecomerela@velymoreexpensive
2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?
Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velydearer,thesubs@tu@oneffectsaysthatyouwillbuylessofthisgood.
3) Haveyoubecomericherorpoorerinrealterms?
AstheGoodhasbecomerela@velydearer,theconsumerispoorerinrealtermsastheycanaffordtobuylessofthegood.
4) Doesthegoodhaveanega@veorposi@veincomeeffect?
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BusJourney’sareaninferiorgoodandassuchhasanega@veincomeeffect.
5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?
AsBusJourney’sareaninferiorgoodwithanega@veincomeeffect,thathasbecomedearerinrealterms,theincomeeffectsaysthatyouwillbuymoreofthisgood.
6) Dotheseeffectsworkinthesamedirec@onoropposite.
Thesubs@tu@oneffectsaysbuylessasithasbecomerela@velydearerandtheincomeeffectsaysbuymoreasyouhavebecomepoorerinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.
7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger?
[email protected]@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuyslessbusjourneys.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuysmorebusjourneys.Aswehavebeentoldintheques@onthatbusjourney’sareaninferiorgood,weknowthatthesubs@tu@oneffectisalwaysstrongerthantheincomeeffect(thatisonedefini@onofaninferiorgood).ForanInferiorGood,thesubs@[email protected],asthepriceofbusjourneysrise,peoplewillbuylessbusjourneysastheposi@vesubs@tu@oneffectisstrongerthanthenega@veincomeeffect.
AnswertoQues0on(d)
1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?
Asthepriceofthegoodhasfallen,thegoodhasbecomerela@velycheaper.
2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?
Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velycheaper,thesubs@tu@oneffectsaysthatyouwillbuymoreofthisgood.
3) Haveyoubecomericherorpoorerinrealterms?
AstheGoodhasbecomerela@velycheaper,theconsumerisricherinrealtermsastheycanaffordtobuymoreofthegood.
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4) Doesthegoodhaveanega@veorposi@veincomeeffect?
BusJourney’sareaninferiorgoodandassuchhasanega@veincomeeffect.
5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?
AsBusJourney’sareaninferiorgoodwithanega@veincomeeffect,thathasbecomecheaperinrealterms,theincomeeffectsaysthatyouwillbuylessofthisgood.
6) Dotheseeffectsworkinthesamedirec@onoropposite.
Thesubs@tu@oneffectsaysbuymoreasithasbecomerela@velycheaperandtheincomeeffectsaysbuylessasyouhavebecomericherinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.
7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger?
[email protected]@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuysmorebusjourneys.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuyslessbusjourneys.Aswehavebeentoldintheques@onthatbusjourney’sareaninferiorgood,weknowthatthesubs@tu@oneffectisalwaysstrongerthantheincomeeffect(thatisonedefini@onofaninferiorgood).ForanInferiorGood,thesubs@[email protected],asthepriceofbusjourneysfall,peoplewillbuymorebusjourneysastheposi@vesubs@tu@oneffectisstrongerthanthenega@veincomeeffect.
AnswertoQues0on(e)
1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?
Asthepriceofthegoodhasfallen,thegoodhasbecomerela@velycheaper.
2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?
Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velycheaper,thesubs@tu@oneffectsaysthatyouwillbuymoreofthisgood.
3) Haveyoubecomericherorpoorerinrealterms?
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AstheGoodhasbecomerela@velycheaper,theconsumerisricherinrealtermsastheycanaffordtobuymoreofthegood.
4) Doesthegoodhaveanega@veorposi@veincomeeffect?
Potatoesareagiffengoodandassuchhasanega@veincomeeffect.
5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?
AsPotatoesareagiffengoodwithanega@veincomeeffect,thathasbecomecheaperinrealterms,theincomeeffectsaysthatyouwillbuylessofthisgood.
6) Dotheseeffectsworkinthesamedirec@onoropposite.
Thesubs@tu@oneffectsaysbuymoreasithasbecomerela@velycheaperandtheincomeeffectsaysbuylessasyouhavebecomericherinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.
7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger?
[email protected]@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuysmorepotatoes.OrtheIncomeeffectisstrongerthanthesubs@tu@oneffectandtheconsumerbuyslesspotatoes.Wehavebeentoldintheques@onthatpotatoesareagiffengood,weknowthattheincomeeffectisalwaysstrongerthanthesubs@tu@oneffect(thatisonedefini@onofangiffengood).ForaGiffenGood,theincomeeffectisalwaysstrongerthanthesubs@[email protected],asthepriceofpotatoesfall,peoplewillbuylesspotatoesastheposi@vesubs@tu@oneffectisweakerthanthenega@veincomeeffect.
AnswertoQues0on(f)
1) Hasthegoodbecomerela@velycheaperorrela@velymoreexpensive?
Asthepriceofthegoodhasrisen,thegoodhasbecomerela@velydearer.
2) Whatdoesthesubs@tu@oneffectsayhowthiswouldeffectdemand?
Thesubs@tu@oneffectsaysthatconsumersalwaysbuymoreofarela@velycheapergood.Asthisgoodhasbecomerela@velydearer,thesubs@tu@oneffectsaysthatyouwillbuylessofthisgood.
3) Haveyoubecomericherorpoorerinrealterms?
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AstheGoodhasbecomerela@velydearer,theconsumerispoorerinrealtermsastheycanaffordtobuylessofthegood.
4) Doesthegoodhaveanega@veorposi@veincomeeffect?
Riceisagiffengoodandassuchhasanega@veincomeeffect.
5) Whatdoestheincomeeffectsayabouthowthiswouldeffectdemand?
Asriceisagiffengoodwithanega@veincomeeffect,thathasbecomedearerinrealterms,theincomeeffectsaysthatyouwillbuymoreofthisgood.
6) Dotheseeffectsworkinthesamedirec@onoropposite.
Thesubs@tu@oneffectsaysbuylessasithasbecomerela@velydearerandtheincomeeffectsaysbuymoreasyouhavebecomepoorerinrealterms.Therefore,wehavetoseewhetherthesubs@tu@oneffectortheincomeeffectisbigger,aseachistellingyoutododifferentthings.
7) Iftheyworkinoppositedirec@ons,askwhicheffectisbigger?
[email protected]@tu@oneffectisstrongerthantheincomeeffectandtheconsumerbuyslessrice.OrtheIncomeeffectisstrongerthanthesubs@[email protected]@onthatriceisagiffengood,weknowthattheincomeeffectisalwaysstrongerthanthesubs@tu@oneffect(thatisonedefini@onofangiffengood).ForaGiffenGood,theincomeeffectisalwaysstrongerthanthesubs@[email protected],asthepriceofricerises,peoplewillbuymorepotatoesastheposi@vesubs@tu@oneffectisweakerthanthenega@veincomeeffect.
Summary
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TypeofGoodSubs@tu@on
Effect+ IncomeEffect = PriceEffect
(1)
Normal
Goods
+ + + = PQ
(1)
Normal
Goods
+ + + = PQ
(2)
Inferior
Goods
+ > - = PQ
(2)
Inferior
Goods
+ > - = PQ
(3)
Giffen
Goods
+ < - = PQ
(3)
Giffen
Goods
+ < - = PQ