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2.3 Income/Price Changes &
Income and Substitution effects
2.3.1
2.3.2
2.3.3
2.3.4
Income Consumption Curves
Price Consumption Curves
Income and Substitution Effects
Application with Different Types
of Goods
Application
“Household prices and the great affordability gap”
The Times 5th September 2007
•House prices rising far faster than earnings
•In UK, three times faster
•Price of housing rising so proportion spent on it rises
•Similar patterns happening across developed economies
2.3.1 Income Consumption Curves
If income changes, BC shifts in a parallel fashion (in or out)
If Price changes, BC pivots (in or out)
QB
Income Consumption
Curve
Curve shows
preference for a
good
BC1BC2 BC3
QA
An example: Engel Curves
Food
Spend
As income rises,
proportion spent on
food declines
Income
2.3.2 Price Consumption Curves
QB
U2
U3
U1
(Or all
other
goods)
Price Consumption Curve
0
A1 A2 A3
BC1
BC2
BC3QA
Note that at A1:
Y
PA 
OBC1
At A2:
At A3:
Y
PA 
OBC 2
Y
PA 
OBC 3
PA
Y/OBC1
X
Y/OBC2
PRICE DEMAND
CURVE
X
Y/OBC3
X
QA
A1
A2
A3
Position of the demand curve depends on:
1. Income levels - higher Y is further right D curve is
2. Tastes - stronger these are, further right the D curve
3. Prices of other goods - substitutes and complements
2.3.3 Income and Substitution Effects
In a demand relationship the quantity consumed
changes with price but what does the quantity change
actually consist of?
Substitution Effect - substitute other goods for A as
Price of A rises
Income Effect - as price of A falls, real income rises and
so spend more on all goods
2.3.4 Application to Different Types of Goods
Direction and size of effects varies with type of good
Normal Good
- as price falls, consumption rises
- as income rises, consumption rises
Inferior Good
- as price falls, consumption rises
- as income rises, consumption falls
Giffen Good
- as price falls, consumption falls
- as income rises, consumption falls
Other
Goods
U2
Normal Good
Subs: 1 to 3 or A to C (-ve)
U1
Income: 3 to 2 or C to B
(+ve)
Price
effect:
A
to
B
or
1
to
2
B
A
C
BC2
1 3 2 BC1 BC3
QA
Other
Goods
Inferior Good
Subs: 1 to 3 or A to C (-ve)
Income: 3 to 2 or C to B (-ve)
B
Price effect: A to B or 1 to 2
A
U2
C
U1
BC2
1 2
3
BC1
BC3
QA
Giffen Good
Subs: 1 to 3 or A to C (-ve)
Other
Goods
Income: 3 to 2 or C to B (-ve)
Price effect: A to B or 1 to 2
B
A
U2
C
U1
2 1
3
BC1
BC3
BC2
QA
Housing Market Revisited
Other
Goods
Q1
U1
U2
BC2
H1
H2
BC1 BC3
Housing