Overview
This lecture explains the first reason why the demand curve slopes downward in economics, focusing on the income effect and the relationship between price changes and consumers' real income.
The Demand Curve and Law of Demand
- The demand curve shows the relationship between a good’s price and the quantity demanded, usually sloping downward.
- The law of demand states that as the price of a good falls, the quantity demanded will usually increase, ceteris paribus (all else equal).
- Only a change in the price of the good causes a movement along the demand curve.
- Movement along the curve is from a higher point to a lower point (price falls) or vice versa (price rises).
Nominal Income vs. Real Income
- Nominal income (money income) is the amount of currency earned in a given time period.
- Real income is the purchasing power of nominal income, calculated as nominal income divided by the price of a good.
- Real income tells you how much of a good or service you can buy with your nominal income.
The Income Effect
- The income effect explains that a decrease in price increases a consumer’s real income, allowing them to buy more of the good.
- If prices rise and nominal income stays the same, consumers become poorer in real terms and can buy less of the good.
- If prices fall and nominal income stays the same, consumers become richer in real terms and can buy more.
- The income effect is one of three reasons why the demand curve slopes downward.
Worked Examples
- To find real income: divide nominal income by the price of the good.
- Example: €500 nominal income, price of big macs €5 each ⇒ real income = 100 big macs.
- Changing prices (with constant nominal income) directly changes real income and the quantity of goods consumers can afford.
Real vs. Nominal Income Scenarios
- Income rises, prices constant: richer in real terms.
- Income falls, prices constant: poorer in real terms.
- Income constant, prices rise: poorer in real terms.
- Income constant, prices fall: richer in real terms.
- Income and prices both rise/fall: impact depends on which changes more.
Key Terms & Definitions
- Demand Curve — shows the relationship between the price of a good and the quantity demanded.
- Ceteris Paribus — Latin for "other things equal"; only price changes while other factors stay constant.
- Nominal Income — the amount of currency earned per time period (e.g., weekly salary).
- Real Income — purchasing power of nominal income; nominal income divided by the price of a good.
- Income Effect — when a price change alters real income, affecting the quantity of a good demanded.
Action Items / Next Steps
- Learn definitions of demand curve, ceteris paribus, nominal income, real income, and income effect by heart.
- Practice calculating real income for given scenarios.
- Prepare for upcoming lessons on the other two reasons for the downward-sloping demand curve.