5.3 : adjustment to price changes

• When the price of something increases, people generally buy less of it. This is called the law of demand.
• The own-price elasticity of demand measures how sensitive the quantity demanded of a good is to a price change for that same good. (PED)
• Cross-Price Elasticity of Demand:

  • This tells us what happens to the demand for one good when the price of another good changes.
• XED:

  • Substitutes: If the price of good j increases, the demand for good i (a substitute) goes up (e.g., if movie ticket prices increase, people might rent movies instead).
  • Complements: If the price of good j increases, the demand for good i (a complement) goes down (e.g., if the price of printers increases, people might buy fewer ink cartridges).
• When the price of one good rises (like meals), your budget line rotates inward, meaning you can afford less of everything. This makes you worse off because your purchasing power (what you can buy with your income) decreases.
• • Price increase: Reduces how much you can buy.
  • Budget line rotation: Shows the reduced buying power when a good becomes more expensive.
  • Consumer worse off: With the same income, they can now afford less of both goods.
• If price increases:

  • The budget line rotates inwards meaning we can afford less of everything making the consumer worse off because purchasing power decreases 
  • A price increase makes the consumer worse off by reducing consumption opportunities out of a fixed money income 
  • The consumer’s standard of living falls.
  • The consumer can no longer afford the original consumption bundle
• when the price rises Effects:

  • Budget line becomes steeper 
  • Reflecting rise in relative price 
  • The budget line lies inside the original budget line 
  • The purchasing power of the consumer is reduced 
• When the price of something changes, it impacts the way consumers buy things in two different ways:

  the substitution effect

  the income effect
• Substitution effect: How much more (or less) you buy of a good because its relative price has changed compared to other goods.
• Income effect: How a price change affects your overall buying power (your real income), which can make you feel richer or poorer.
• The substitution effect happens when the price of one good increases, making it more expensive relative to other goods . So, people will switch to buying more of the cheaper good and less of the more expensive one .
• • Substitution Effect: Always reduces the quantity demanded of the good whose price increased because people switch to the relatively cheaper good.
  • The substitution effect is always negative for the good that becomes more expensive because consumers move towards the cheaper alternative.
• The income effect happens when a price change affects how much real income (or purchasing power) you have. If the price of something increases, you can afford less with the same income, making you feel poorer.
• • For normal goods, the income and substitution effects move in the same direction, meaning both effects lead the consumer to buy less of the good when the price increases.
• Income Effect: When prices go up, the consumer feels poorer, so they buy less of both normal goods (like meals and films).
• • For normal goods, the income effect and substitution effect reinforce each other. This means both effects push the consumer to buy less of the good whose price has increased.
• Compensating variation is a thought experiment where we calculate how much extra income a consumer would need to stay as well off as they were before the price change.
• The goal of the substitution effect is to show how consumers change their consumption patterns when prices change.
• If the good is a normal good, when its price rises, people tend to buy less of it. This is why demand curves generally slope downward—as prices rise, quantity demanded falls.
• Inferior Goods and Price Changes

  1. How do inferior goods behave differently?

  • For an inferior good, the income effect works in the opposite direction of the substitution effect.
  • When your real income decreases (due to a price increase or less money available), you might actually buy more of the inferior good, even though the substitution effect tells you to buy less.
• • There are situations where the income effect is so strong that even if the price of the inferior good rises, people buy more of it. This leads to a demand curve that slopes upward—meaning higher prices increase demand.
  • This type of good is called a Giffen good.
• As the price of the Giffen good increases, the quantity demanded also increases (a rare case).
• Giffen Goods:

  • A Giffen good is a special type of inferior good where the income effect outweighs the substitution effect.
• 1. Veblen Goods:

  • Veblen goods behave differently from Giffen goods. These are goods that people buy because they are expensive (luxury goods like Gucci bags).
  • The demand for these goods might increase as their prices rise, but this is due to their prestige or status, not because of the income effect like with Giffen goods.
• when income elasticity is high with luxury goods the income effect outweighs the substitution effect leading to a reduction in the number of films demanded
• Normal Goods:

  • Substitution Effect:
  • If the price of good I increases, the consumer will substitute away from good I to good J, so the substitution effect is negative for good I and positive for good J.
  • Income Effect:
  • The income effect is negative for both goods. When the price of good I increases, the consumer feels poorer because their real income decreases. This causes a decrease in the quantity demanded of both goods, since both are normal goods.
• normal goods:

  • Total Effect:
  • The total effect for good I is negative because both the substitution and income effects lead to lower demand. For good J, the total effect is positive because the substitution effect outweighs the negative income effect.
• 1. Inferior Goods:

  • Substitution Effect:
  • As with normal goods, the substitution effect is negative for good I and positive for good J. When the price of good I increases, consumers substitute towards good J.
  • Income Effect:
  • The income effect is positive for inferior goods. As the price of good I increases, the consumer feels poorer. For inferior goods, this leads to an increase in the quantity demanded because poorer consumers tend to consume more of inferior goods.
• • Total Effect: inferior goods
  • The total effect for good I is ambiguous. The substitution effect leads to a decrease in demand, but the income effect leads to an increase. Whether demand rises or falls depends on which effect dominates.
  • For good J, the total effect is positive, since the substitution effect increases demand, and the income effect further reinforces this.