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Tutorial 6: Consumer and Market Demand (cont.)

 

In the first part of this tutorial we established that the consumer choice model generates an individual consumer's demand curve that shows an inverse relationship between price and the quantity demanded, cæteris paribus, as predicted by the law of demand.

In the second part of this tutorial we saw that if the nonprice determinant income is allowed to change, while price is held constant, the entire demand curve shifts to the right or to the left. By implication, if any of the nonprice determinants change, holding the product's price constant, the demand curve will shift.

Now we take a look at why price and quantity demanded vary inversely.

 

Substitution and Income Effects Top of page.

As I write this, gasoline prices are rising. This makes many Americans angry and they demand that their government do something to stop the "greedy, rapacious, capitalist dogs" from stealing their hard earned income. After all, "It's gasoline, ya gotta have it. So we just have to pay!" While this may be true in the immediate (or market) period, i.e., while you're standing at the pump, it is not true in the short run, and it is especially not true in the long run. Let's look at a short run response. (We'll examine long run responses later.)

Many people act as if they mistakenly believe that when the price of a good rises, consumers of that good are forced to either pay up or go without. In fact, when the price of a good increases, even gasoline, which has a price inelastic demand, one buys a little less of it -- people don't just pay up or do without it all together. Higher prices force one to look for substitutes. What's a substitute for gasoline? Gasoline at other filling stations whose prices are lower, of course. Also, shorter trips, less time spent "flooring it"!, sharing a ride, even trading in your gas-guzzling Ford Explorer (ignoring the tires!) for a more fuel efficient Honda CRX... And this is an important economics lesson -- there are substitutes for everything!

Well then, when the price of something rises we look for substitutes. This is one reason why demand curves slope downward. The substitution effect of an increase in the price of a good leads to less of that good being purchased as one pursues more of a relatively cheaper substitute. The other reason quantity demanded varies inversely with price is called the income effect. As the price of a good rises, one's real income (income divided by the price level) falls. So one cannot afford to buy as many goods in total as before. Using the same example, one may buy a little less gasoline and eat out less often.

 

Substitution and Income Effects in the Consumer Choice Model Top of page.

When price rises, quantity demanded falls because of the substitution effect and the income effect. Let's use the consumer choice model to separate the decrease in quantity demanded into two parts, one for each reason.

Sketch out the consumer choice model showing the consumer at an optimum bundle of two goods, Food and Clothing. Here are the initial parameter values:

I = $80/period; Pc = $2 each; Pf = $2 each; C* = 20 units/period; and F* = 20 units/period. Assume Food is a normal good.

If we raise the price of Food from $2 to $8 per unit, cæteris paribus, the budget line becomes steeper, rotating leftward along the x-axis. (See Figure 2 in Tutorial 6a.) Now we know the consumer is made worse off when a price increases. What if we were able to offset that higher price with higher income (just as an experiment)? If we raise income, we can eliminate the income effect of the price increase. Our goal would be to raise income enough that the consumer would be just as happy as before the price increase. I wonder if there would be any change in the consumption bundle if we eliminate the income effect?

As we raise income, the budget line shifts outward, parallel to the original. When it is tangent to the initial indifference curve, we know the consumer will be just as happy as before. Does this increase in income leave the consumer with the same consumption bundle as before? No! See Figure 6 below. After increasing income we see that at the new point of tangency (of U1 and B1) the consumption bundle has less Food (10 units/period) and more Clothing (40 units/period).

 

Figure 6

Graph showing the substitution and income effects of an increase in the price of food.

By increasing the consumer's income we were able to eliminate the income effect of the price increase. We can now see that when the price of a good increases, AND real income held constant, the consumer substitutes more clothing for less food. (If that seems odd remember that there are only two goods in the entire consumption set of this consumer...) So the drop in Food consumption from 20 to 10 units per period is due entirely to the substitution effect of the price increase.

[Note: The previous three paragraphs deserve to be read carefully!]

Now let's take that income away (it was only an experiment after all!). Figure 7 shows the result. The budget line drops parallel to its new position and becomes tangent to a new, lower indifference curve at F* = 5 units/period and C* = 20 units/period. So now the drop in Food consumption from 10 to 5 units is due entirely to the income effect (real income is the only thing that changed).

 

Figure 7

Graph showing the total effect of an increase in the price of food on the consumption of food.

 

As price increases from $2 to $8 per unit, the total effect on the consumption of Food is a drop from 20 to 5 units per period. This is what we saw in the first part of Tutorial 6. Now we know that this drop takes two steps. The drop in Food consumption from 20 to 10 units per period is due to the substitution effect of the price increase and the drop from 10 to 5 units per period is due to the income effect of a price increase.

This will take some practice, so...

Now it's time to "do the thing".

Click on the following link to download the Consumer Choice Workbook. Work through Tutorial 6 Questions 1 - 4 then 5 - 8. This will heop you to improve your understanding of why the demand curve generated by the consumer choice model shows an inverse relationship between price and quantity demanded.

Return here when you have finished.

Need help downloading the Excel file?

 

Ok, so I hope you're beginning to get a handle on how we use the consumer choice model to separate the change in the consumption of a good due to a change in its price. But somewhere along the way I'm sure you wondered why we are so concerned about precisely how much of the change is due to each effect...

Precision isn't really our goal. Knowing that there are two reasons why quantity demanded drops when price increases can help us understand some real world issues that seem counterintuitive otherwise. Suppose an economist goes to Washington and recommends that gasoline consumption be taxed (in order to increase its price and drop consumption) and then suggests that gasoline consumers be given an increase in income equal to the amount they spend on those taxes. Senator Snodgrass is bound to raise his hairy eyebrows and interject, loudly, that any moron could see that this cash rebate will completely offset the decrease in consumption brought about by the tax. But, understanding that consumption falls for two reasons when price increases will let you understand why the plan will still result in lower gasoline consumption! You can work this out for yourself...

Now it's time to "do the thing".

Click on the following link to download the Consumer Choice Workbook. Work through tutorial 6 Questions 9 - 12. This will help to improve your understanding of why we study the seemingly artificial separation of the substitution and income effects of a price change.

Return here when you have finished.

Need help downloading the Excel file?

 

Now would be a good time to answer, or revisit your earlier answer to, Good Faith Effort 13.

 

So what have we witnessed? We changed the price of one good in the consumer choice model and kept track of the total change in the quantity of that good consumed. Then we changed the consumer's income so that they could consume a bundle of goods that would leave them as happy as they were before the price increase. That allowed us to isolate the substitution effect of a price change. Finally, we brought income back to its original level allowing us to isolate the income effect of a price change.

Next we see how the individual consumer's demand curve relates to the market demand curve.