Behind the Demand Curve:
Consumer Choice
Explaining the law of demand
• The Substitution effect
▫ Remember the law of demand, this why the
demand curve slopes downward
▫ An alternative way to think about why demand
curves slope downward is to focus on opportunity
cost
▫ The change in the quantity demanded as the good has
become relatively cheaper is substituted for the good
that was become relatively more expensive….this is
known as the substitution effect
 When a good absorbs only a small share of the typical
consumer’s income, the substitution effect is essentially
the sole explanation of why the market demand curve
slopes downward.
▫ There are some goods i.e. food and housing, that
account for a substantial share of many consumers’
incomes…..this brings in the income effect
• The Income effect
▫ Example: half of family income is spent on rental
housing
 Price of housing increases everywhere and will have
a substitution effect on the family’s demand
 All things being equal, the family will have an incentive
to consume less housing
 In a real sense the family will also be made poorer by
that higher housing price
▫ Income will by less housing than before
 When income is adjusted to reflect its true
purchasing power it is called real income
 In contrast money that has not been adjusted is
called money income or nominal income
• The income effect is the change in quantity of a good
demanded that results from a change in the overall
purchasing power of the consumer’s income due to a
change in the price of that good.
Distinction between the two effects
▫ For the majority of goods and services, the income
effect is not important and has no significant
effect on individual consumption
 Market demand curves slope downward solely
because of substitution effect
▫ When it matters at all, income effect usually
reinforces the substitution effect
 Vast majority of goods are normal goods (goods for
which demand decreases when income falls)
 This reinforces the substitution effect
 With inferior goods- income effect and substitution
effect work in opposite directions
 Substitution effect decrease the quantity demanded as
its price increases, the income effect of a price increase
for an inferior good is an increase in quantity
demanded
 Price increase lowers real income , as real income falls
demand for an inferior good increases
Defining and measuring elasticity
▫ Economist use the concept of elasticity to measure
the responsiveness of one variable to change in
another
▫ Price elasticity of demand
 Measures the responsiveness of quantity of demand
to changes in price
▫ Calculating the price elasticity of demand
• Calculate % change in demand
▫ % change in quantity demand = change in
quantity demanded/ initial quantity demanded X
100
• Calculate % change in price
▫ % change in price = change in price/ initial price X
100
• Calculate price elasticity of demand
• Find ratio of the % change in Quantity
demanded and in % change in price
▫ Price elasticity of demand = %change in quantity
demanded/ % change in price