Income

and
Substitution
Effect
 Marginal Utility and the Law of
Demand
• Price of fried clams rises
• Does it change the marginal utility that a
consumer gets from an additional pound of
clams?
• No, but it reduces the marginal utility per
dollar spent on fried clams.
• The decrease in marginal utility per dollar
spent on clams gives the consumer an
incentive to consume fewer clams when the
price of clams rises
 Marginal Utility and the Law of
Demand
• Explanation: The optimal consumption rule
• A utility-maximizing consumer chooses a
consumption bundle for which the marginal
utility per dollar spent on all goods is the
same.
• If marginal utility per dollar on clams falls
because the price of clams rises, the
consumer can increase his or her utility by
purchasing fewer clams and more of other
goods
 Marginal Utility and the Law of
Demand
• If the price of clams falls, the opposite
happens
• The marginal utility per dollar spent on clams
increases at any given level of clam
consumption
• A consumer can increase his or her utility by
purchasing more clams and less of other
goods when the price of clams falls
 Marginal Utility and the Law of
Demand

• When the price of a good increases, an

individual will normally consume less of
that good and more of other goods

• When the price of a good decreases, an

individual will normally consume more
of that good and less of other goods
 Marginal Utility and the Law of
Demand
• Consuming less when price increases and
more when price decreases explains why the
individual demand slopes downward
– The law of demand
• If individual demand curve slopes downward,
the market demand curve will slope
downward
• Demand curves sloping downward also show
opportunity costs of goods and services
 Substitution Effect and the Law of
Demand
• The effect of a price change on the
quantity consumed is always present
• The substitution effect is the change in
the quantity consumed as the consumer
substitutes the good that has become
relatively cheaper in place of the good
that has become relatively more
expensive
 Substitution Effect and the Law of
Demand
• If the good absorbs only a small share of the
consumer’s spending, the substitution effect
is essentially the complete explanation of
why the individual demand curve of that
consumer slopes downward
• And, when a good absorbs only a small share
of the typical consumer’s spending, the
substitution effect is essentially the sole
explanation of why the market demand
curve slopes downward
 Substitution Effect and the Law of
Demand
• Exceptions are found
• I.e. Housing Market
• Goods like housing absorb a large share
of a typical consumer’s spending
• This makes the individual demand curve
and the market demand curve become
more complicated
 The Income Effect
• As said, for the majority of goods, the
substitution effect is sole reason behind
the individual and market demand
curves

• Food and housing are exceptions due to

the amount consumers have to spend
 The Income Effect
• Example:
• A family spends half its income on rental
housing
• Housing prices increase everywhere
• This will have a substitution effect (other
things equal) the family will have an
incentive to consume less housing and
more of other goods
 The Income Effect
• The family though will be made poorer by
the higher housing price – its income will buy
less housing than before
• The amount of income adjusted to reflect its
true purchasing power is termed “real
income”
• The reduction in the consumer’s real income
will have an additional effect on the family’s
consumption bundle, including its
consumption of housing
 The Income Effect
• The income effect of a change in the price of
a good is the change in the quantity of that
good consumed that results from a change in
the consumer’s purchasing power due to the
change in the price of that good

• In this example, a change in the price of a

good effectively changes a consumer’s
income because it alters the consumer’s
purchasing power
 The Income Effect
• The distinction between substitution effect
and income effect:

1.For the majority of goods and services, the

income effect is not important and has no
significant effect on individual
consumption. The market demand curve
slope downward solely because of the
substitution effect
 The Income Effect
2. When it matters at all, the income effect
usually reinforces the substitution effect.
The price of a good that absorbs a
substantial share of income rises,
consumers of that good become a bit poorer
because their purchasing power falls.
• The vast majority of goods are normal
goods, goods for which demand decreases
when income falls
 The Income Effect
• For an inferior good, a good for which
demand increases when income falls, the
income and substitution effect work in
opposite directions
• The substitution effect tends to produce a
decrease in the quantity of any good
demanded as its price increases but for an
inferior good, the income effect of a price
increases tends to produce an increase in the
quantity demanded
 The Income Effect
• As a result of all of this, there a
hypothetical cases involving inferior
goods in which distinction between
income and substitution effects are
important
• Typically, income effects are important
only for a limited number of goods
 Income
and
Substitution
Effect
Notes
 Marginal Utility and the Law of
Demand
• Price of fried clams rises
• Does it change the marginal utility that a
consumer gets from an additional pound of
clams?

• The decrease in marginal utility per dollar

spent on clams gives the consumer an
incentive to consume fewer clams when the
price of clams rises
 Marginal Utility and the Law of
Demand
• Explanation: The optimal consumption rule

• If marginal utility per dollar on clams falls

because the price of clams rises, the
consumer can increase his or her utility by
purchasing fewer clams and more of other
goods
 Marginal Utility and the Law of
Demand
• If the price of clams falls, the opposite
happens

• A consumer can increase his or her utility by

purchasing more clams and less of other
goods when the price of clams falls
Marginal Utility and the Law of
Demand
 Marginal Utility and the Law of
Demand
• Consuming less when price increases and
more when price decreases explains why the
individual demand slopes ______________

• If individual demand curve slopes downward,

the market demand curve will slope
_______________
• Demand curves sloping downward also show
__________________of goods and services
 Substitution Effect and the Law of
Demand
• The effect of a price change on the quantity
consumed is always present
 Substitution Effect and the Law of
Demand
• If the good absorbs only a small share of the
consumer’s spending, the substitution effect is
essentially the complete explanation of why the
individual demand curve of that consumer
slopes downward
• And, when a good absorbs only a small share of
the typical consumer’s spending, the
substitution effect is essentially the sole
explanation of why the market demand curve
slopes downward
 Substitution Effect and the Law of
Demand
• Exceptions are found

• Goods like ______________ absorb a large

share of a typical consumer’s spending
• This makes the individual demand curve and
the market demand curve become more
complicated
 The Income Effect
• As said, for the majority of goods, the
substitution effect is sole reason behind
the individual and market demand
curves

• ___________________are exceptions
due to the amount consumers have to
spend
 The Income Effect
• Example:

• This will have a ______________ effect

(other things equal) the family will have an
incentive to consume less housing and more
of other goods
 The Income Effect
• The family though will be made poorer by the
higher housing price – its income will buy less
housing than before
• The amount of income adjusted to reflect its
true purchasing power is termed “real income”
• The reduction in the consumer’s real income will
have an additional effect on the family’s
consumption bundle, including its consumption
of housing
 The Income Effect
• The income effect of a change in the price of a
good is the change in the quantity of that good
consumed that results from a change in the
consumer’s purchasing power due to the change
in the price of that good

• In this example, a change in the price of a good

effectively changes a consumer’s income
because it alters the consumer’s purchasing
power
 The Income Effect
• The distinction between substitution effect
and income effect:
1.
 The Income Effect
2.

• The vast majority of goods are normal

goods, goods for which demand decreases
when income falls
 The Income Effect
• For an inferior good,

• The substitution effect tends to produce a

_____________ in the quantity of any good
demanded as its price ____________ but for
an inferior good, the income effect of a price
increases tends to produce an ___________
in the quantity _______________
 The Income Effect
• As a result of all of this, there a
hypothetical cases involving inferior
goods in which distinction between
income and substitution effects are
important
• Typically, income effects are important
only for a limited number of goods