6.2 How Changes in Income and Prices Affect Consumption Choices

Consumer decisions shape demand in the market. Income, prices, preferences, and opportunity costs all play crucial roles in determining what people buy. Understanding these factors helps explain why demand curves slope downward and how they shift.

Substitution and income effects further explain consumer behavior when prices change. The law of demand, elasticity concepts, and utility maximization principles provide a framework for analyzing how consumers make choices to get the most satisfaction from their limited resources.

Consumer Decisions and Demand

Factors shaping consumer decisions

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• Income
  • Higher income increases purchasing power and demand for normal goods (luxury cars, organic food)
  • Lower income decreases demand for normal goods
  • Inferior goods experience increased demand when income decreases (generic brands, public transportation)
• Prices
  • Higher prices decrease quantity demanded (gasoline, concert tickets)
  • Lower prices increase quantity demanded
  • Price changes cause movement along the demand curve
• Preferences
  • Tastes and preferences influence demand for goods and services
  • Changes in preferences shift the demand curve
    • Increased preference shifts demand curve to the right (smartphones, eco-friendly products)
    • Decreased preference shifts demand curve to the left (CDs, fur coats)
• Opportunity cost
  • The value of the next best alternative forgone when making a choice

Substitution vs income effects

• Substitution effect
  • When a good's price increases, consumers buy less of that good and more of its substitutes
  • Occurs because the relative price of the good has increased compared to its substitutes (beef vs chicken)
• Income effect
  • When a good's price increases, consumers' purchasing power decreases, leading to decreased quantity demanded
  • The higher price reduces consumers' real income, affecting their ability to buy goods
• Total effect of a price change is the sum of the substitution and income effects
  • For normal goods, substitution and income effects work in the same direction, reducing quantity demanded when price increases
  • For inferior goods, substitution and income effects work in opposite directions (generic vs name-brand cereal)

Demand concepts in consumer choices

• Law of demand
  • Inverse relationship between price and quantity demanded, ceteris paribus (all else being equal)
• Factors that shift the demand curve
  • Changes in income (job promotion, recession)
  • Changes in prices of related goods (substitutes and complements)
  • Changes in preferences (health trends, fashion)
  • Changes in expectations (future price changes, income expectations)
  • Changes in the number of consumers (population growth, immigration)
• Elasticity of demand
  • Measures the responsiveness of quantity demanded to changes in price
  • Elastic demand: Quantity demanded changes by a larger percentage than the price change (luxury goods)
  • Inelastic demand: Quantity demanded changes by a smaller percentage than the price change (necessities like insulin)
  • Unitary elastic demand: Quantity demanded changes by the same percentage as the price change
  • Price elasticity of demand: Measures the percentage change in quantity demanded in response to a percentage change in price
  • Income elasticity of demand: Measures the percentage change in quantity demanded in response to a percentage change in income
  • Cross-price elasticity of demand: Measures the percentage change in quantity demanded of one good in response to a percentage change in the price of another good

Utility maximization in decision-making

• Governments
  • Aim to maximize social welfare by implementing policies that consider consumer utility
  • Taxation, subsidies, and regulations can influence consumer behavior and address market failures (carbon tax, education subsidies)
• Businesses
  • Aim to maximize profits by understanding consumer preferences and utility
  • Use market research to gather information on consumer behavior and preferences (surveys, focus groups)
  • Develop pricing strategies based on the elasticity of demand for their products (price discrimination, bundling)
  • Design products and services that align with consumer preferences and maximize utility (user-friendly interfaces, customizable options)

Utility Maximization and Consumer Equilibrium

Factors shaping consumer decisions

• Utility maximization
  • Consumers aim to maximize their total utility subject to their budget constraint
  • Marginal utility (MU): Additional satisfaction gained from consuming one more unit of a good
  • Law of diminishing marginal utility: MU decreases as more units of a good are consumed (first slice of pizza vs fifth slice)
• Consumer equilibrium
  • Achieved when the marginal utility per dollar spent $(MU/P)$ is equal for all goods consumed
  • At equilibrium: $MU_A/P_A = MU_B/P_B = ... = MU_N/P_N$
  • Consumers allocate their income to maximize total utility (spending on various goods and services)

Consumer Choice Analysis

• Indifference curves: Represent combinations of goods that provide the same level of satisfaction to a consumer
• Consumer surplus: The difference between the maximum price a consumer is willing to pay for a good and the actual price they pay
• Budget constraints: Represent the combinations of goods a consumer can afford given their income and prices of goods