6.2 How Changes in Income and Prices Affect Consumption Choices
4 min read•Last Updated on June 24, 2024
Consumer decisions shape demand in the economy. Income, prices, and preferences influence what people buy. Understanding these factors helps explain how consumers respond to changes in their economic environment.
The substitution and income effects further illuminate consumer behavior. When prices change, consumers adjust their purchases based on relative costs and purchasing power. This knowledge is crucial for analyzing real-world economic scenarios.
Consumer Decisions and Demand
Factors shaping consumer decisions
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Income
Higher income increases purchasing power enables consumers to buy more goods and services (designer clothing, luxury cars)
Lower income reduces purchasing power forces consumers to cut back on purchases (generic brands, used goods)
Prices
Higher prices for a good or service reduce the quantity demanded, all else equal (gasoline, concert tickets)
Lower prices for a good or service increase the quantity demanded, all else equal (seasonal sales, discounted airfare)
Relative prices of substitute goods (tea vs coffee) and complement goods (hamburgers vs hamburger buns) also affect consumer decisions
Preferences
Tastes and preferences determine the relative desirability of different goods and services (organic food, eco-friendly products)
Changes in preferences can shift demand curves affects the quantity demanded at each price level (plant-based meat alternatives, streaming services)
Substitution effect vs income effect
Substitution effect
When the price of a good increases, consumers tend to buy less of that good and more of its substitutes, holding real income constant (switching from brand-name to generic medications)
When the price of a good decreases, consumers tend to buy more of that good and less of its substitutes, holding real income constant (choosing fresh produce over frozen when prices drop)
Income effect
When the price of a good increases, consumers' real income decreases leads to reduced consumption of normal goods (dining out less frequently when restaurant prices rise)
When the price of a good decreases, consumers' real income increases leads to increased consumption of normal goods (buying more clothing when prices are discounted)
Net effect on quantity demanded
The net change in quantity demanded due to a price change is the sum of the substitution effect and income effect
For normal goods, the substitution effect and income effect work in the same direction when the price changes (both effects lead to increased demand for smartphones when prices fall)
For inferior goods, the substitution effect and income effect work in opposite directions when the price changes (substitution effect increases demand for instant noodles when prices fall, but income effect decreases demand as consumers switch to higher-quality alternatives)
Applications of Consumer Choice Theory
Demand concepts in real-world scenarios
Price elasticity of demand
Measures the responsiveness of quantity demanded to changes in price
Goods with elastic demand see large changes in quantity demanded when prices change (luxury goods, airline tickets)
Goods with inelastic demand see small changes in quantity demanded when prices change (insulin, gasoline)
Income elasticity of demand
Measures the responsiveness of quantity demanded to changes in income
Normal goods have positive income elasticity of demand quantity demanded increases as income rises (organic produce, premium cable subscriptions)
Inferior goods have negative income elasticity of demand quantity demanded decreases as income rises (public transportation, second-hand clothing)
Cross-price elasticity of demand
Measures the responsiveness of quantity demanded of one good to changes in the price of another good
Substitute goods have positive cross-price elasticity of demand an increase in the price of one good leads to an increase in demand for the other good (Lyft rides vs Uber rides)
Complement goods have negative cross-price elasticity of demand an increase in the price of one good leads to a decrease in demand for the other good (printers vs ink cartridges)
Utility maximization in policy and strategy
Government policies
Taxes on goods and services effectively increase prices leads to reduced quantity demanded (cigarette taxes, sugary drink taxes)
Subsidies on goods and services effectively decrease prices leads to increased quantity demanded (electric vehicle subsidies, agricultural subsidies)
Policies that affect consumer income, such as taxation and transfer payments, can shift demand curves (earned income tax credit, universal basic income)
Business strategies
Pricing decisions should consider the price elasticity of demand for a firm's products (inelastic demand allows for higher prices without significant loss in sales)
Firms can use price discrimination to maximize profits by charging different prices to different consumer segments based on their willingness to pay (student discounts, senior discounts)
Product differentiation and branding can influence consumer preferences creates demand for a firm's products (Apple's ecosystem, Nike's brand identity)
Bundling and tying strategies can leverage complementary goods to increase sales and profits (cable TV packages, printer and ink cartridge bundles)
Understanding consumer surplus helps firms set prices that capture more value from consumers while maintaining demand
Consumer choice analysis
Budget constraint represents the combinations of goods a consumer can afford given their income and prices
Indifference curves show combinations of goods that provide equal satisfaction to a consumer
Consumers maximize utility by choosing the point where an indifference curve is tangent to the budget constraint
The marginal rate of substitution at this point equals the ratio of prices, reflecting the opportunity cost of consuming one good in terms of another