Income Effects and Substitution Effects in Markets

Demand Curve and Price Effects

• Demand Curve: Represents consumer purchasing behavior at various price levels.
• Price Changes:
  • Decrease in Price: Typically leads to increased purchases (expansion down the curve).
  • Increase in Price: Typically leads to decreased purchases (contraction up the curve).
  • Movement Along the Curve: Caused by changes in market price only.
  • Shifts in the Curve: Caused by changes in other demand conditions.

Income and Substitution Effects

• Objective: Understanding why price changes affect purchasing behavior.

Example: Lamb Market

• Price Change:
  • From June 2014 to November 2015, the price dropped from £5 to £3.50 per kilo (30-35% decrease).
• Economic Theory: Predicts increased demand due to income and substitution effects.

Income Effect

• Definition: Real purchasing power changes as the price changes.
• Scenario: If the price of lamb decreases, consumers can buy more with the same budget.
• Normal Good:
  • Positive income elasticity of demand.
  • Demand increases with real income.
• Inferior Good:
  • Demand decreases as real income increases.

Substitution Effect

• Definition: Relative price changes lead consumers to switch between products.
• Scenario: Price drop in lamb makes it cheaper compared to beef, pork, chicken.
• Consumer Behavior: Switch from substitutes to cheaper product (lamb).
• Cross-Price Elasticity: High if substitutes are considered close, leading to strong substitution effects.

Factors Influencing Demand

• Combined Effects: Demand for lamb depends on the size and direction of income and substitution effects.
• Demographics:
  • Age Profile: Older consumers tend to consume more lamb.
  • Tastes and Preferences: Change over time; less lamb consumption among younger populations.

Conclusion

• Uncertain Demand Increase: A price drop doesn’t guarantee a surge in consumption due to demographic factors.
• Overall Topic: Revision on income vs. substitution effects in market demand.