Summary of Income Effects, Substitution Effects, and Elasticity

Income Effects and Substitution Effects

  • Law of Demand: Explains demand based on income and substitution effects.

  • Price elasticity of demand measures consumer responsiveness to price changes.

Demand Curve

  • Generally slopes downward due to substitution effect.

  • Negative slope indicates inverse relationship between price and quantity demanded.

  • Variations: Curve can be straight or not; vertical indicates perfectly inelastic demand, horizontal indicates perfectly elastic demand.

Substitution Effect

  • Price increase leads to decreased consumption of that good and increased consumption of alternatives.

  • Price decrease leads to increased consumption of that good and decreased consumption of alternatives.

  • Related to opportunity cost; substitutes are sought when relative prices change.

Income Effect

  • Significant for goods that represent substantial income shares (e.g., housing, food).

  • Higher prices reduce purchasing power (real income) leading to changes in quantity demanded.

  • Purchasing power declines as prices rise, affecting demand.

Interaction of Effects

  • For most goods, substitution effect drives demand curve downward; income effect generally reinforces substitution.

  • Opposing effects notably seen in inferior goods where higher prices can increase demand (Giffen goods).

Elasticity of Demand

  • Elasticity measures responsiveness of quantity demanded to price changes.

  • Price elasticity formula: ext{Elasticity} = rac{ ext{% change in quantity demanded}}{ ext{% change in price}}

  • Higher elasticity indicates strong consumer reactions, lower indicates weak reactions.

Inelastic Demand

  • Demand insensitive to price changes; small quantity changes despite price fluctuations.

  • Demand curve is steep (looks like an “I”).

  • Characteristics: Few substitutes, necessities, small income portions, immediate need.

Elastic Demand

  • Demand sensitive to price changes; significant quantity changes for price fluctuations.

  • Demand curve is flatter (looks like an “E”).

  • Characteristics: Many substitutes, luxury items, large income portions, ample decision time.

Perfectly Inelastic and Elastic Demand

  • Perfectly inelastic: Coefficient = 0; quantity demanded does not change with price.

  • Unit elastic: Coefficient = 1; % change in quantity equals % change in price.

  • Perfectly elastic: Coefficient = ∞; any price change leads to infinite quantity change.