🛒principles of microeconomics review
6.2 How Changes in Income and Prices Affect Consumption Choices
Last Updated on June 25, 2024
Consumer decisions shape demand in the market. Income, prices, preferences, and opportunity costs all play crucial roles in determining what people buy. Understanding these factors helps explain why demand curves slope downward and how they shift.
Substitution and income effects further explain consumer behavior when prices change. The law of demand, elasticity concepts, and utility maximization principles provide a framework for analyzing how consumers make choices to get the most satisfaction from their limited resources.
Consumer Decisions and Demand
Factors shaping consumer decisions
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- Income
- Higher income increases purchasing power and demand for normal goods (luxury cars, organic food)
- Lower income decreases demand for normal goods
- Inferior goods experience increased demand when income decreases (generic brands, public transportation)
- Prices
- Higher prices decrease quantity demanded (gasoline, concert tickets)
- Lower prices increase quantity demanded
- Price changes cause movement along the demand curve
- Preferences
- Tastes and preferences influence demand for goods and services
- Changes in preferences shift the demand curve
- Increased preference shifts demand curve to the right (smartphones, eco-friendly products)
- Decreased preference shifts demand curve to the left (CDs, fur coats)
- Opportunity cost
- The value of the next best alternative forgone when making a choice
Substitution vs income effects
- Substitution effect
- When a good's price increases, consumers buy less of that good and more of its substitutes
- Occurs because the relative price of the good has increased compared to its substitutes (beef vs chicken)
- Income effect
- When a good's price increases, consumers' purchasing power decreases, leading to decreased quantity demanded
- The higher price reduces consumers' real income, affecting their ability to buy goods
- Total effect of a price change is the sum of the substitution and income effects
- For normal goods, substitution and income effects work in the same direction, reducing quantity demanded when price increases
- For inferior goods, substitution and income effects work in opposite directions (generic vs name-brand cereal)
Demand concepts in consumer choices
- Law of demand
- Inverse relationship between price and quantity demanded, ceteris paribus (all else being equal)
- Factors that shift the demand curve
- Changes in income (job promotion, recession)
- Changes in prices of related goods (substitutes and complements)
- Changes in preferences (health trends, fashion)
- Changes in expectations (future price changes, income expectations)
- Changes in the number of consumers (population growth, immigration)
- Elasticity of demand
- Measures the responsiveness of quantity demanded to changes in price
- Elastic demand: Quantity demanded changes by a larger percentage than the price change (luxury goods)
- Inelastic demand: Quantity demanded changes by a smaller percentage than the price change (necessities like insulin)
- Unitary elastic demand: Quantity demanded changes by the same percentage as the price change
- Price elasticity of demand: Measures the percentage change in quantity demanded in response to a percentage change in price
- Income elasticity of demand: Measures the percentage change in quantity demanded in response to a percentage change in income
- Cross-price elasticity of demand: Measures the percentage change in quantity demanded of one good in response to a percentage change in the price of another good
Utility maximization in decision-making
- Governments
- Aim to maximize social welfare by implementing policies that consider consumer utility
- Taxation, subsidies, and regulations can influence consumer behavior and address market failures (carbon tax, education subsidies)
- Businesses
- Aim to maximize profits by understanding consumer preferences and utility
- Use market research to gather information on consumer behavior and preferences (surveys, focus groups)
- Develop pricing strategies based on the elasticity of demand for their products (price discrimination, bundling)
- Design products and services that align with consumer preferences and maximize utility (user-friendly interfaces, customizable options)
Utility Maximization and Consumer Equilibrium
Factors shaping consumer decisions
- Utility maximization
- Consumers aim to maximize their total utility subject to their budget constraint
- Marginal utility (MU): Additional satisfaction gained from consuming one more unit of a good
- Law of diminishing marginal utility: MU decreases as more units of a good are consumed (first slice of pizza vs fifth slice)
- Consumer equilibrium
- Achieved when the marginal utility per dollar spent is equal for all goods consumed
- At equilibrium:
- Consumers allocate their income to maximize total utility (spending on various goods and services)
Consumer Choice Analysis
- Indifference curves: Represent combinations of goods that provide the same level of satisfaction to a consumer
- Consumer surplus: The difference between the maximum price a consumer is willing to pay for a good and the actual price they pay
- Budget constraints: Represent the combinations of goods a consumer can afford given their income and prices of goods
Key Terms to Review (25)
Utility: Utility refers to the satisfaction or benefit that an individual derives from consuming a good or service. It is a fundamental concept in economics that helps explain how and why individuals make choices to maximize their well-being.
Elasticity: Elasticity is a measure of how responsive a dependent variable is to changes in an independent variable. It is a fundamental concept in microeconomics that describes the sensitivity of one economic variable, such as quantity demanded or supplied, to changes in another variable, such as price or income.
Marginal Analysis: Marginal analysis is a decision-making tool used in economics to evaluate the additional benefits and costs associated with producing or consuming one more unit of a good or service. It involves examining the change in total cost or total revenue resulting from a small change in output or consumption.
Ceteris Paribus: Ceteris paribus is a Latin phrase that means 'all other things being equal' or 'holding all other factors constant.' It is a crucial concept in economic analysis that allows economists to isolate the effect of one variable on another, while assuming that all other relevant factors remain unchanged.
Marginal Utility: Marginal utility is the additional satisfaction or value a consumer derives from consuming one more unit of a good or service. It represents the change in total utility as the consumption of a product increases by one unit.
Law of Diminishing Marginal Utility: The law of diminishing marginal utility states that as a person consumes more of a good, the additional satisfaction or utility derived from each successive unit of that good decreases. In other words, the marginal utility, or the benefit gained from consuming one more unit of a good, diminishes with each additional unit consumed.
Income Effect: The income effect is the change in the quantity demanded of a good or service resulting from a change in a consumer's real income, while holding the price of the good or service constant. It describes how a consumer's purchasing power and consumption patterns are affected by changes in their available income.
Utility Maximization: Utility maximization is the economic principle that individuals seek to obtain the greatest possible satisfaction or well-being from their consumption of goods and services, given their budget constraints. It is a fundamental concept in microeconomic theory that guides consumer decision-making and helps explain how changes in income and prices affect consumption choices.
Normal Goods: Normal goods are a type of consumer good for which demand increases as a consumer's income increases. As a person's income rises, their demand for normal goods tends to rise as well, assuming other factors remain constant.
Consumer Equilibrium: Consumer equilibrium refers to the state where a consumer maximizes their utility or satisfaction from consuming a bundle of goods, given their budget constraint. It represents the optimal allocation of a consumer's limited income across different goods and services to achieve the highest possible level of utility.
Indifference Curves: Indifference curves are graphical representations of a consumer's preferences that show all the combinations of two goods that provide the consumer with an equal level of satisfaction or utility. They depict the tradeoffs a consumer is willing to make between two goods while maintaining the same overall level of utility.
Law of Demand: The law of demand is an economic principle that states that as the price of a good or service increases, the quantity demanded of that good or service decreases, and vice versa. This inverse relationship between price and quantity demanded is a fundamental concept in microeconomics.
Substitution Effect: The substitution effect refers to the change in consumption of a good or service due to a change in its relative price, while holding the consumer's real income constant. It describes how consumers adjust their purchasing decisions when the price of one item changes compared to other items they could buy.
Budget Constraint: A budget constraint is the limit on the total amount of money an individual or household can spend on goods and services, based on their available income and the prices of those goods and services. It represents the maximum combination of goods and services that can be purchased given the available resources.
Demand Curve: The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity demanded of that good or service. It depicts how the quantity demanded changes as the price changes, ceteris paribus (all other factors remaining constant).
Consumer Surplus: Consumer surplus is the difference between the maximum price a consumer is willing to pay for a good or service and the actual price they pay. It represents the additional benefit or satisfaction consumers receive beyond what they have to pay, essentially the economic gain from a transaction from the consumer's perspective.
Inferior Goods: Inferior goods are a type of consumer good for which demand decreases as a consumer's income increases. These are goods that people tend to consume less of as they become wealthier, in contrast to normal or superior goods where demand increases with rising income.
Price Elasticity of Demand: Price elasticity of demand measures the responsiveness of the quantity demanded of a good or service to changes in its price. It quantifies how much the quantity demanded changes when the price changes, providing insights into consumer behavior and the dynamics of supply and demand in a market.
Inelastic Demand: Inelastic demand refers to a situation where the quantity demanded of a good or service changes by a smaller percentage than the change in its price. In other words, consumers are relatively insensitive to price changes for that particular product or service.
Elastic Demand: Elastic demand refers to a situation where the quantity demanded of a good or service is highly responsive to changes in its price. When demand is elastic, a small change in price leads to a relatively large change in the quantity demanded.
Giffen Good: A Giffen good is a type of inferior good where the demand for the good increases as the price of the good increases, contradicting the typical law of demand. This occurs when consumers have limited budgets and substitute away from more expensive goods towards the Giffen good as their incomes decline.
Engel Curve: The Engel curve is a graphical representation that shows the relationship between a consumer's income and the quantity of a particular good or service they demand. It illustrates how the consumption of a good or service changes as the consumer's income changes, while holding prices constant.
Income Elasticity of Demand: Income elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to changes in the consumer's income. It indicates how the demand for a product changes when the consumer's income changes, holding all other factors constant.
Unitary Elastic Demand: Unitary elastic demand refers to a situation where the percentage change in quantity demanded is exactly equal to the percentage change in price. This means that a 1% change in price leads to a 1% change in quantity demanded in the opposite direction, resulting in a price elasticity of demand value of -1.0.
Cross-Price Elasticity of Demand: Cross-price elasticity of demand measures the responsiveness of the demand for one good to a change in the price of another good. It quantifies the degree to which the demand for a product is affected by the price changes of a related product.