A.P. Microeconomics
Substitution & Income Effect
Complete Budget as Group
•
On Back of sheet answer the following
questions:
1. All rent prices drop $100.
a. Is this an increase in your income? Explain.
b. Would any of your decisions change?
Explain.
2. Uncle Jed passes on and creates a trust
fund for one of you increasing your
income 25% per month.
a. How much is your income now?
b. What different choices would you make?
Income Effects on Choices
in Output Markets
Income Effect- As income increases or as
the price of commonly purchased good
decreases, a household’s real income (or
overall buying power) increases.
Ex. Getting a Raise
Getting Laid Off
National Fuel Raising Prices by 20%
Verizon cutting phone bills 33%
Income Effect
• When Income Rises, then Demand
increases = more buying power.
• When the price of goods that we buy often
is lowered, then we have more money (an
increase in a household’s real income). =
more buying power.
Substitution Effects on Choices
in Output Markets
• Substitution Effect- the idea that
households will buy more of the good or
service that costs less than its substitutes.
– What can I buy that gives me the most utility?
– When rent prices drop do I change to a
different apartment, substituting a bigger
apartment but now the same rent as before?
Income vs. Substitute Effect
Both the income and substitution effects imply a negative
relationship between price and quantity demanded – in
other words, downward-sloping demand. When the
price of something falls, ceteris paribus, we are better
off, and we are likely to buy more of that good and other
goods (income effect). Because lower prices also
means “less expensive relative to substitutes,” we are
likely to buy more of the good (substitution effect). When
the price of something rises, we are worse off, and we
will buy less of it (income effect). Higher price also
means “more expensive relative to substitutes,” and we
are likely to buy less of it and more of other goods
(substitution effect).
Consumer Surplus
• I am willing to pay $75 for the Tickle Me
Elmo. The store price for Elmo is $40. I
found Elmo at a store, how much money
did “save”?
• The difference between the maximum
amount a person is willing to pay for a
good and its current market price.
Consumer Surplus
• Consumer Surplus: is the amount that
consumers benefit by being able to
purchase a product for a price that is less
than they would be willing to pay
• Let’s Graph It!!
Consumer Paradox
• Adam Smith wrote about this phenomenon in
1776. In our consumer society we too often put
a high price on items that have little intrinsic
value and vice versa.
• Diamond/Water Paradox
• The things with the greatest value in use
frequently have little or no value in exchange
(water has no marginal utility).
• The things with the greatest value in exchange
frequently have little to no value in use (diamond
has a very large marginal utility)