For centuries, economic thinkers, from Adam Smith to John Maynard Keynes, have tried to identify the elusive formula that makes some countries more prosperous and successful than others. My curiosity about this topic spurred me, as a young professor of economics in the late 1970s, to research new ways of measuring national competitiveness.
Household Behavior and Consumer Choice
(Part C)
Charles Lamson
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Income and Substitution Effects
Although the idea of utility (total satisfaction received from consuming a good or service) is a helpful way of thinking about the choice process, there is an explanation for downward-sloping demand curves that does not rely on the concept of utility or the assumption of diminishing marginal utility [Ceteris paribus, as consumption increases the marginal utility (the change in the utility from an increase in the consumption of that good or service) derived from each additional unit declines]. This explanation centers on income and substitution effects. Keeping in mind that consumers face constrained choices, consider the probable response of a household to a decline in the price of some heavily used product, ceteris paribus. How might a household currently consuming many goods be likely to respond to a fall in the price of one of those goods if its income, its preferences, and all other prices remained unchanged? The household would face a new budget constraint and its final choice of all goods and services might change. A decline in the price of gasoline, for example, may affect not only how much gasoline you purchase but also what kind of car you buy, when and how much you travel, where you go, and (not so directly) how many movies you see this month and how many projects around the house you'll get done. The Income Effect Price changes affect households in two ways. First, if we assume that households confine their choices to products that improve their well-being, then a decline in the price of any product, ceteris paribus, makes the household unequivocally better off. In other words, if our household continues to buy the same exact same amount of every good and service after the price decrease, it will have income left over. That extra income may be spent on the product whose price has declined, hereafter called good X, or on other products. The change in consumption of X due to this improvement in well-being is called the income effect of a price change.  Suppose that I live in Florida and that four times a year I fly to Nashville to visit my mother. Suppose further that last year a round trip ticket to Nashville cost $400. Thus I spend a total of $1,600 per year on trips to visit Mom. This year, however, the increased competition among the airlines has led one airline to offer round trip tickets to Nashville for $200. Assuming that the price remains at $200 all year, I can now fly home exactly the same number of times, and I will have spent $800 less for airline tickets than I did last year. Now that I am better off, I have additional opportunities. I could fly home a fifth time this year, leaving $600 ($800 - $200) to spend on other things, or I could fly home the same number of times (4) and spend all the extra $800 on other things. When the price of something we buy falls, we are better off. When the price of something we buy rises, we are worse off. Look at Figure 4 from Part 25 of this analysis and reintroduced below. When the price of Thai meals fell, the opportunity set facing Tom and Ann expanded they were able to afford more Thai meals, more jazz club trips, or more of both. They were unequivocally better off because of the price decline. In a sense, they're "real" income was higher.  Now recall from Part 11 of this analysis the definition of a normal good. When income rises, demand for normal goods increases. Most goods are normal goods. Because of the price decline,Tom and Ann can afford to buy more. If Thai food is a normal good, a decline in the price of Thai food should lead to an increase in the quantity demanded of Thai food.  The Substitution Effect The fact that a price decline leaves households better off is only part of the story. When the price of a product falls, that product also becomes relatively cheaper. That is, it becomes more attractive relative to potential substitutes. A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X. This shift is called the substitution effect of a price change. Earlier, we made the point that the "real" cost of price of a good is what one must sacrifice to consume it. This opportunity cost is determined by relative at prices. To see why this is so, consider again the choice that I face when a round trip ticket to Nashville cost $400. Each trip that I take requires a sacrifice of $400 worth of other goods and services. When the price drops to $200, the opportunity cost of a ticket has dropped by $200. In other words, after the price decline, I have to sacrifice only $200 (instead of $400) worth of other goods and services to visit mom. To clarify the distinction between the income and substitution effects in your mind, imagine how I would be affected if two things happened to me at the same time. First, the price of round trip air travel between Florida and Nashville drops from $400 to $200. Second, my income is reduced by $800. I am now faced with new relative prices, but assuming I flew home four times last year I am no better off now than I was before the price of a ticket declined. The decrease in the price of air travel has exactly offset my decrease in income. I am still likely to take more trips home why? The opportunity cost of a trip is now lower, ceteris paribus---that is, assuming no change in the prices of other goods and services. A trip to Nashville now requires a sacrifice of only $200 worth of other goods and services, not the $400 worth that it did before. Thus I will substitute away from other goods toward trips to see my mother.  Everything works in the opposite direction when a price rises, ceteris paribus. A price increase makes households worse off. If income and other prices do not change, spending the same amount of money buys less, and households will be forced to buy less. This is the income effect. In addition, when the price of a product rises, the item becomes more expensive relative to potential substitutes, and the household is likely to substitute other goods for it. This is the substitution effect. What do the income and substitution effects tell us about the demand curve? 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 affect). Because lower price 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). Figure 7 summarizes the income and substitution effects of a price change.   *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 112-114* end |
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