TOPIC 23
Changes in consumer
choice
CONSUMER’S OPTIMUM CHOICE
Quantity
of Pepsi
Optimum
I3
I2
I1
Budget constraint
0 Quantity of pizzas
1
CHANGES IN CONSUMER’S CHOICES
• Using the previous figure we will now see how
changes in
– consumer income,
– a good’s price &
– the price of other goods
affect consumer choices?
HOW CHANGES IN INCOME AFFECT
A CONSUMER’S CHOICES
• Suppose that income increases.
– With a higher income, the consumer can afford
more of both goods.
– The budget constraint shifts rightwards.
• The expanded budget constraint enables the
consumer to choose a better combination of
Pepsi and pizza on a higher indifference curve.
2
HOW CHANGES IN INCOME AFFECT
A CONSUMER’S CHOICES –
NORMAL GOODS
Quantity
of Pepsi New budget constraint
1. An increase in income shifts the
budget constraint rightward ...
New optimum
3. . ... and
Pepsi
consumption. Initial
optimum I2
Initial
budget
constraint I1
0 Quantity
of pizzas
2. . ... raising pizza consumption ...
HOW CHANGES IN INCOME AFFECT
A CONSUMER’S CHOICES –
NORMAL GOODS
• If a consumer buys more of a good when
income rises, it is a normal good.
• In the previous graph, at the new optimum the
consumer purchases more pizza, as well as,
Pepsi.
– Both goods are normal goods
3
HOW CHANGES IN INCOME AFFECT
A CONSUMER’S CHOICES –
INFERIOR GOOD
Quantity
of Pepsi New budget constraint
1. When an increase in income shifts the
3. ... but budget constraint rightward . . .
Pepsi Initial
consumption optimum
falls, making
Pepsi an New optimum
inferior good.
Initial
budget I1 I2
constraint
0 Quantity
of Pizza
2. ... pizza consumption rises, making pizza a normal good ...
HOW CHANGES IN INCOME AFFECT
A CONSUMER’S CHOICES –
INFERIOR GOOD
• If a consumer buys less of a good when
income rises, it is an inferior good.
• In the previous graph, at the new optimum the
consumer purchases more pizza but less
Pepsi.
– Pizza is a normal good
– Pepsi is an inferior good
4
HOW CHANGES IN PRICES AFFECT
A CONSUMER’S CHOICES
• A reduction in the price of a good measured on
the vertical axis rotates the budget constraint
clockwise
– making the budget constraint steeper.
• A reduction in the price of a good measured on
the horizontal axis rotates the budget
constraint counter-clockwise
– making the budget constraint flatter.
HOW CHANGES IN PRICES AFFECT
A CONSUMER’S CHOICES
• Suppose that the price of Pepsi falls from $2 to
$1.
– The budget constraint rotates clockwise
– The lower price expands the consumer’s set of
buying opportunities.
– Notice that point A is on both budget lines because if
the consumer spends her entire $1000 on pizza,
then the change in price of Pepsi becomes
irrelevant.
5
HOW CHANGES IN PRICES AFFECT
A CONSUMER’S CHOICES
Quantity
of Pepsi
New budget constraint
1,000 D
New optimum
B 1. A fall in the price of Pepsi rotates
500
the budget constraint outward ...
3. ... and
raising Pepsi Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100 Quantity
2. . . . reducing pizza consumption ... of pizzas
HOW CHANGES IN PRICES AFFECT
A CONSUMER’S CHOICES
• We can see the standard outcome
– a reduced Pepsi price increases the quantity of Pepsi
demanded.
• Pepsi becomes cheaper relative to pizza so
consumers substitute pizza with Pepsi.
– Called substitution effect.
• The consumer’s purchasing power has risen
because a price has fallen.
– Called income effect – give consumers the opportunity
to buy more of both goods.
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INCOME AND SUBSTITUTION
EFFECTS
• Thus, the impact of a change in the price of a
good can be divided into two effects:
– Income effect – the change in consumption that
results when a price change moves the consumer to
a higher or lower indifference curve.
– Substitution effect – the change in consumption that
results when a price change moves the consumer
along a given indifference curve to another point
with a new marginal rate of substitution.
INCOME AND SUBSTITUTION EFFECTS
Quantity
of Pepsi
New budget constraint
C New optimum
Income
effect B
Initial optimum
Substitution Initial
effect budget
constraint A
I2
I1
0 Quantity
Substitution effect of pizzas
Income effect
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INCOME AND SUBSTITUTION
EFFECTS
• The movement from point A to point C (price
effect) can be divided into two steps:
– First, the consumer moves along the initial
indifference curve I1 from point A to point B
(substitution effect).
– Second, the consumer moves to the higher
indifference curve I2 by moving from point B to point
C (income effect).
INCOME AND SUBSTITUTION
EFFECTS
Income Substitution
Good effect effect Total effect
Consumer is
richer, so she Pepsi is relatively Income and substitution
buys more cheaper, so the effects act in the same
Pepsi (normal consumer buys more direction, so the consumer
Pepsi good). Pepsi. buys more Pepsi.
The consumer
is richer, so she Pizza is relatively Income and substitution
buys more more expensive, so effects act in opposite
pizza (normal the consumer buys directions – the total effect on
Pizzas good). fewer pizzas. pizza is ambiguous.
8
INCOME AND SUBSTITUTION EFFECTS
Quantity
of Pepsi
New budget constraint
B
Income
effect C New optimum
Substitution Initial
budget Initial optimum
effect A
constraint
I2
I1
0 Quantity
Substitution effect of pizzas
Income effect
INCOME AND SUBSTITUTION
EFFECTS
Income Substitution
Good effect effect Total effect
Consumer is Pepsi is relatively Income and substitution
richer, so she cheaper, so the effects act in the opposite
buys less Pepsi consumer buys more direction, so the total effect on
Pepsi (inferior good). Pepsi. Pepsi is ambiguous.
The consumer
is richer, so she Pizza is relatively Income and substitution
buys more more expensive, so effects act in opposite
pizza (normal the consumer buys directions – the total effect on
Pizzas good). fewer pizzas. pizza is ambiguous.
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INCOME AND SUBSTITUTION
EFFECTS – KEY POINT
• Total effect of price change equals
– substitution effect
• always works in opposite direction to the price change
– plus income effect
• works in opposite direction to the price change if good is
normal
• but same direction to the price change if good is inferior.
DERIVING THE DEMAND CURVE
• A consumer’s demand curve summarises the
optimal choices made by consumers in
response to a change in price.
(The consumer’s optimum) (The demand curve for Pepsi)
Quantity Price of
of Pepsi New budget constraint Pepsi
B A
750 $2
I2
B
1
A
250 Demand
I1
0 Initial budget Quantity 0 250 750 Quantity
constraint of pizzas of Pepsi
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SUMMARY
• When the price of a good falls, the impact on a
consumer’s choices can be broken down into
an income effect & substitution effect.
• The income effect is the change in
consumption that arises because a lower price
makes the consumer better off.
• Reflected by a movement from one
indifference curve to another.
SUMMARY
• The substitution effect is change in
consumption that arises because a price
change encourages greater consumption of
good now relatively cheaper.
• Reflected by a movement along an indifference
curve to a point with a different slope.
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