Consumer behavior is shaped by income and substitution effects when prices change. These effects explain why demand shifts for different goods, influencing purchasing decisions and market dynamics.

Understanding these effects is key to grasping consumer choices. They reveal how price changes impact buying patterns, helping predict market trends and informing economic policies that affect everyday purchases.

Income vs Substitution Effects

Defining Income and Substitution Effects

• Income effect changes consumption due to real income changes from price shifts
  • Holds other factors constant
  • Example: Higher real income from lower food prices leads to more restaurant meals
• Substitution effect alters consumption from relative price changes
  • Keeps real income constant
  • Example: Lower chicken prices lead to substituting chicken for beef
• Effects occur simultaneously with price changes
  • Economic analysis isolates individual impacts
• Graphical representation differs
  • Income effect shifts entire budget line
  • Substitution effect changes budget line slope

Impact on Normal vs Inferior Goods

• Normal goods experience aligned effects when prices decrease
  • Both effects increase consumption
  • Example: Lower computer prices lead to buying more computers and accessories
• Inferior goods have opposing effects with price decreases
  • Substitution effect increases consumption
  • Income effect decreases consumption
  • Example: Lower bus fare may reduce ridership as people can afford cars
• Magnitude varies by good type and consumer preferences
  • Luxury goods often have larger income effects (jewelry)
  • Necessity goods typically have smaller income effects (basic groceries)

Price Changes and Consumer Behavior

Consumer Response to Price Decreases

• Price drops alter purchasing power and relative prices
• Normal goods see increased consumption
  • Substitution effect makes good relatively cheaper
  • Income effect increases purchasing power
  • Example: Lower smartphone prices lead to more purchases and upgrades
• Inferior goods may see overall consumption decrease
  • Substitution effect increases consumption
  • Income effect decreases consumption
  • Net effect depends on relative strengths
  • Example: Decreased prices of generic brands may reduce sales as consumers opt for name brands

Indirect Effects and Special Cases

• Related goods affected through cross-price effects
  • Complementary goods (printers and ink cartridges)
  • Substitute goods (tea and coffee)
• Luxury goods exhibit larger income effects than necessities
  • Example: Price drop in luxury cars has more impact than in basic transportation
• Giffen good phenomenon explained by income and substitution effects
  • Rare case where price increase leads to higher demand
  • Example: Historically observed with staple foods in impoverished areas

Normal vs Inferior Goods

Characteristics and Elasticity

• Normal goods increase demand as income rises
  • Positive income elasticity of demand
  • Example: Organic produce sales increase with higher incomes
• Inferior goods decrease demand with rising income
  • Negative income elasticity of demand
  • Example: Instant noodle consumption decreases as incomes grow
• Luxury goods subset of normal goods
  • Income elasticity greater than 1
  • Demand increases more than proportionally to income
  • Example: High-end watches, designer clothing
• Necessity goods another subset of normal goods
  • Income elasticity between 0 and 1
  • Demand increases less than proportionally to income
  • Example: Basic clothing, household cleaning supplies

Applications and Importance

• Classification varies across income levels and consumer groups
  • Middle-class view of luxury cars vs. upper-class perspective
• Indifference curve analysis illustrates consumption patterns
  • Shows how good type affects choices as income changes
• Crucial for business demand predictions
  • Helps forecast sales based on economic trends
• Important for policymakers assessing economic policy impacts
  • Aids in understanding effects on different consumer segments
  • Example: Tax policy effects on various income groups

Income, Substitution, and Elasticity

Price Elasticity Components

• Price elasticity measures demand responsiveness to price changes
  • Incorporates both income and substitution effects
  • Example: Gasoline demand changes with price fluctuations
• Strong substitution effects lead to higher price elasticity
  • Consumers easily switch to alternatives
  • Example: High elasticity between different brands of bottled water
• Income effect contribution depends on good type
  • Normal or inferior good classification matters
  • Proportion of income spent on good affects impact
  • Example: Housing typically has a larger income effect than small household items

Elasticity Variations Across Goods

• Normal goods tend to have more elastic demand
  • Income and substitution effects align
  • Example: Electronics often show high elasticity
• Inferior goods may have less elastic demand
  • Income effect partially offsets substitution effect
  • Example: Public transportation might show lower elasticity in some areas
• Relative magnitude explains elasticity variations
  • Differs across good types and consumer segments
  • Example: Luxury cars more elastic than basic transportation
• Understanding elasticity composition crucial for strategies
  • Informs pricing decisions for businesses
  • Guides policy decisions affecting consumer welfare
  • Example: Tax policy on different goods (necessities vs. luxuries)