Download The income effect

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Every household must make three basic decisions:
1.How much of each product, or output, to demand
2. How much labor to supply
3. How much to spend today and how much to save for the future
Factors that influence the quantity of a given good or service demanded
by a single household include:
The price of the product in question.
The income available to the household.
The household’s amount of accumulated wealth.
The prices of related products available to the household.
The household’s tastes and preferences.
The household’s expectations about future income, wealth, and
prices.
This is the budget constraint when income equals $100 dollars per month, the price of movies is $10
each, and the price of a books is $ 5.
 If we spent all of our money on books, we could consume at point A.
 In order to see two movies, which cost a total of $20, you will only have $80 to spend on books,
allowing you to buy a maximum of 16 books. This combination is point B.
 If you were to spend all of your money going to the movies, you could see 10 movies (is point C).
The combination of these points makes up the budget constraint.
All the points under (and including) the budget constraint are called the
opportunity set or choice set.
budget constraint
The limits imposed on household
choices by income, wealth,
and product prices.
A
choice set or opportunity set
is the set of options that is defined
by a budget constraint.
 Point E is unattainable given
the current income prices.
 Point D does not exhaust the
entire income available.
In general, the budget constraint can be written:
PXX + PYY = I,
Where
PX = the price of X,
X = the quantity of X consumed,
PY = the price of Y,
Y = the quantity of Y consumed,
I = household income.
utility
The satisfaction, or reward, a product yields relative to its
alternatives. The basis of choice.
utility
a numerical indicator of
a person’s preferences in which
higher levels of utility indicate a greater preference.
marginal utility (MU)
The additional satisfaction gained by the consumption or use
of one more unit of something.
total utility
The total amount of satisfaction obtained from consumption
of a good or service.
Marginal utility comes only from the last unit consumed; total
utility comes from all units consumed.
When marginal utility is zero, total utility stops rising.
law of diminishing marginal utility
The more of any one good consumed in a given period, the less satisfaction (utility)
generated by consuming each additional (marginal) unit of the same good.
Diminishing marginal utility helps to explain why
demand slopes down.
Marginal utility falls with each additional unit
consumed, so people are not willing to pay as much.
Price changes affect households in two ways:
The income effect:
Consumption changes because purchasing power changes.
The substitution effect:
Consumption changes because opportunity costs change.
Income effect:
 When the price of a product
falls, a consumer has more
purchasing power with the same
amount of income.
 When the price of a product
rises, a consumer has less
purchasing power with the same
amount of income.
Substitution effect:
 When the price of a product falls,
that product becomes more
attractive relative to potential
substitutes.
 When the price of a product
rises, that product becomes less
attractive relative to potential
substitutes.
Water is plentiful.
If the price of water was zero, you
might argue that water has no value.
But it does. Consumers enjoy a huge
consumer surplus from water
consumption.
Household willingness to pay far
exceeds the zero price.
The lesson of the diamond/water paradox is that:
1.
the things with the greatest value in use
frequently have little or no value in exchange, and
2.
the things with the greatest value in exchange
frequently have little or no value in use.
As in output markets, households face constrained choices in
input markets. They must decide:
1.
2.
3.
Whether to work
How much to work
What kind of a job to work at
These decisions are affected by:
1.
2.
3.
The availability of jobs
Market wage rates
The skill possessed by the household
The wage rate can be thought of as the price—or the opportunity cost—of
the benefits of either unpaid work or leisure.
INCOME AND SUBSTITUTION EFFECTS OF A WAGE
CHANGE
labor supply curve
A diagram that shows the quantity of labor supplied at different
wage rates. Its shape depends on how households react to
changes in the wage rate.
INCOME AND SUBSTITUTION EFFECTS OF A WAGE CHANGE
An increase in the wage rate affects households in two ways, known as the
substitution and income effects.
 The substitution effect of a higher wage
means that the opportunity cost of
leisure is higher. The household will buy
less leisure (supply more labor).
 When the substitution effect outweighs
the income effect, the labor supply
curve slopes upward.
INCOME AND SUBSTITUTION EFFECTS OF A WAGE CHANGE
An increase in the wage rate affects households in two ways, known as the
substitution and income effects.
 The income effect of a higher wage
means that households can afford to buy
more leisure (offer less labor).
 When the income effect outweighs the
substitution effect, the result is a
“backward-bending” labor supply curve.
 budget constraint
 law of diminishing marginal utility
 choice set or opportunity set
 marginal utility (MU)
 consumer surplus
 real income
 diamond/water paradox
 substitution effect of a price change
 homogeneous products
 total utility
 income effect of a price change
 utility
 labor supply curve