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Income

In: Business and Management

Submitted By sdfga
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Income and substitution effects The inverse relationship between price and quantity demanded results from both an income effect and a substitution effect. A change in price causes a change in both the relative price of the product and the purchasing power of the consumer’s income. Either one of these changes taken in isolation would bring about a change in the quantity demanded. One can think of the total change in quantity demanded brought about by a change in price as being the sum of these two isolated changes. In algebraic terms, we ∆Qd  ∆Qd   ∆Qd  can write: =  substitution effect +   income effect. Our strategy will be to find the income ∆P  ∆P   ∆P  effect; the substitution effect is then found as the difference between the total effect (the left-hand side of the equation) and the income effect. ∆Qd ∆I  ∆Qd  Consider, then, the income effect term. It can be rewritten as  .  income effect = ∆I ∆P  ∆P  That is, the income effect is the product of two terms. The first term measures the amount by which a change in income changes quantity demanded; the second term measures the amount by which a change in the price changes a consumer’s income, or purchasing power. Multiplying them gives us the income ∆I dollars; each one of these dollars effect: a price increase reduces the consumer’s purchasing power by ∆P ∆Qd reduces the quantity demanded by units. ∆I For example, consider an individual who is currently purchasing four DVDs per month. How might we measure the income effect of a $1 increase in the price of DVDs? Each of these four discs now costs $1 more so, all else equal, our consumer will be spending $4 more each month on DVDs. This reduces her purchasing power by $4. In general, each dollar increase in the price will reduce purchasing ∆I = – Qd. Substituting this into our formula, we power by an amount equal to the quantity demanded: ∆P ∆Qd

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