6.2 Income and Substitution Effects of Price Changes Flashcards
What is purchasing power or “real income”?
real income
Income expressed in terms of the purchasing power of money income—that is, the quantity of goods and services that can be purchased with the money income.
What is the substitution effect?
substitution effect
The change in the quantity of a product demanded resulting from a change in its relative price (holding real income constant).
What does the substitution effect do?
The substitution effect increases the quantity demanded of a product whose price has fallen and reduces the quantity demanded of a product whose price has risen.
What is the income effect?
income effect
The change in the quantity of a product demanded resulting from a change in real income (holding relative prices constant).
What dose the income effect lead to?
The income effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good.
Why will the demand curve for any normal curve always be negativly sloped?
Because of the combined operation of the income and substitution effects, the demand curve for any normal good will be negatively sloped. A fall in price will increase the quantity demanded.
Who is Sir Robert Giffen?
Great interest was generated by the English economist Sir Robert Giffen (1837–1910) when he claimed to observe a situation with an upward-sloping demand curve. He observed that when the price of bread increased (due to an increase in the price of imported wheat), members of the British working class increased their consumption of bread.
What is a Giffen good?
Giffen good
An inferior good for which the income effect outweighs the substitution effect so that the demand curve is positively sloped.
Products with positively sloped demand curves are known as Giffen goods and they have two key characteristics.
What are the two characteristics that Giffin goods posses?
First, the good must be an inferior good, meaning that a reduction in real income leads households to purchase more of that good.
Second, the good must take a large proportion of total household expenditure and therefore have a large income effect.
Why do we not find many Giffin goods today?
Though possible, such cases are all but unknown today for in all but the poorest societies, because typical households do not spend large proportions of their incomes on any single inferior good.
What is a Conspicuous consumption good?
A second case of positively sloped demand curves relates to what are called conspicuous consumption goods. Thorstein Veblen (1857–1929), in The Theory of the Leisure Class, noted that some products were consumed not for their intrinsic qualities but because they had “snob appeal.” He suggested that the more expensive such a product became, the greater might be its ability to confer status on its purchaser.
What appeals to people about Conspicuous Consumption Goods?
First, in a case where individuals appear to buy more goods at a higher price because of the high price, there is actually something else going on in addition to a price change. What really appeals to such individuals is that other people think they paid a high price—this is the basis for the “snob appeal.”
Is the income effect big or small for products that take up a relatively small amount of ones income?
Small
