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Income Effects and Substitution Effects

Income Effects
Income effects and substitution effects are two non-price determinants of demand. Changes to the income level of the customers in a market shift the position of the demand curve for a product (in contrast to a movement along the demand curve or to a change in quantity demanded.) An overall increase in the level of income, for a normal good, will shift the demand curve to the right. That is, at any price on the original demand curve, more of the product will be demanded after the increase in income as reflected by the new demand curve.

A normal good is any good for which an increase in income relates to an increase in demand. In contrast to normal goods are inferior goods. An inferior good is any good for which an increase in income relates to a decrease in demand. To explain the differences between normal goods and inferior goods, I submit the following examples: Steak is a normal good. In general, as people have more expendable income, they purchase more steak. For many people, steak is a desirable food. Boxed macaroni and cheese is an inferior good. Some people purchase boxed macaroni and cheese because they prefer the product, but many people purchase it as a lower-cost alternative to foods that they prefer, such as steak. When income is increased, the demand curve for boxed macaroni and cheese, as does the demand curve for any other inferior product, moves to the left.

As buyers earn higher incomes, the demand curves for normal products move to the right and the demand curves for inferior products move to the left.

Another important item that can change is the income of the consumer. As long as the prices remain constant, changing the income will create a parallel shift of the budget constraint. Increasing the income will shift the budget constraint right since more of both can be bought, and decreasing income will shift it left. (www.wikipedia.com)
external image Consumer_constraint_choice_income_shift.png(wikipedia.com)
Depending on the indifference curves the amount of a good bought can either increase, decrease or stay the same when income increases. In the diagram below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an inferior good since the amount bought decreased as the income increases.(www.wikipedia.com)
external image Inferior_good.png(wikipedia.com)
external image ac61b498fdf796c4fa5da4f5f877268a.png is the change in the demand for good 1 when we change income from m' to m, holding the price of good 1 fixed at p1':
external image 7a649d677a66f328ad61209198a8f8cd.png (www.wikipedia.com)

Substitution effects
Substitution effects and complementary effects may also move or effect the location of demand curves. Substitute goods are those products that compete for sales with the good being evaluated. When considering the purchase of a cola, Coke and Pepsi may be substitutes. If the price of Pepsi would increase while the price of Coke remains constant, the demand curve for Coke would move to the right. If the price of Pepsi would decrease while the price of Coke remains constant, the demand curve for Coke would move to the left. The substitution effect is a non-price determinant, the price of Coke was held constant in both cases.

The complementary effect occurs when two goods are purchased or consumed in relation to each other. Ketchup is a complementary good to French fries. If the demand for French fries increases, it should be expected that the demand for ketchup would also increase. The reverse is not necessarily true. If the demand for ketchup increases, the demand for French fries may or may not increase. The increase in demand for ketchup may be due to an increase in the demand for meatloaf.

Every price change can be decomposed into an income effect and a substitution effect. The substitution effect is a price change that changes the slope of the budget constraint, but leaves the consumer on the same indifference curve. This effect will always cause the consumer to substitute away from the good that is becoming comparatively more expensive. If the good in question is a normal good, then the income effect will reinforce the substitution effect. If the good is inferior, then the income effect will lessen the substitution effect. If the income effect is opposite and stronger than the substitution effect, the consumer will buy more of the good when it becomes more expensive. An example of this might be a Giffen good. (www.wikipedia.com)

external image Substitution_effect.png (www.wikipedia.com)
Substitution effect, external image 2aff67dc6ffa41a79f3f91ec8281eeae.png, is the change in the demand for good 1 when the price of good 1 changes to p1' and, at the same time, the money income changes to m':
external image 2fad80cdc08a2b5d69d1a416cb7a981a.png (www.wikipedia.com)


Questions:

1. Consider goods X and Y. If an increase in the price of X causes an increase in the quantity demanded of good Y, then:
a. X is a complementary good to Y.
b. Y is complementary to X.
c. X and Y are substitutes.
d. None of the above.

Answer: d. None of the above. Any change in the price of either a complementary good or of a substitute good will cause a change in demand curve, not just a movement along the demand curve.

2. X is a substitute for Y. With new technology, the quality of good X is improved:
a. The demand curve for Y will shift to the right.
b. The demand curve for Y will shift to the left.
c. The quantity demanded of Y will increase.
d. The quantity demanded of Y will decrease.

Answer: With improved quality, more of good X will be demanded. The demand for Y will decrease or the curve will move to the left. Answer b.

3. If the government lifts the subsidies on peanuts and the price of peanut butter doubles:
a. The quantity demanded of grape jelly will double.
b. The demand for grape jelly will increase.
c. The demand for grape jelly will decrease.
d. The quantity demanded of grape jelly will decrease by 50%.

Answer: c. Grape jelly and peanut butter are complementary goods.

4. Coke and Pepsi are substitute products; both are colas. Coke has improved the quality and consistency of their product. Pepsi has countered with a very effective advertisement campaign. How will this affect the demand curves of Coke and Pepsi?
a. The demand curve for Coke will move to the right and the demand curve for Pepsi will move to the right.
b. The quantity demanded for Coke will decrease and the quantity demanded for Pepsi will increase.
c. The quantity demanded for both Coke and Pepsi will increase.
d. The changes in the demand curves will be indeterminate. Either curve could move either direction.

Answer: Changes to a substitute product will change the demand curve. With two simultaneous changes to substitute products, the end result can not be predicted.