Page 4 - Economics and Personal Finance

Now ask yourself a question: Would you buy a slice of pizza for
lunch if it cost $2.00? Many of us would. Some of us might even substitution effect
buy more than one slice. But would you buy the same slice of pizza the reaction of consumers to
an increase in a good’s price by
if it cost $4.00? Fewer of us would buy it at that price. Even real consuming less of that good and
pizza lovers might buy just one or two slices instead of three or more of other goods
four. How many of us would buy a slice for $10.00? Probably very income effect
few would do that. As the price of pizza increases, fewer of us are changes in consumption that
willing to buy it. That is the law of demand in action. result from changes in real income

What is the substitution effect?

One factor influencing demand is the number of substitutes that
exist and are demanded. For example, you could buy a nice car
for much less than a $50,000 sports car. You could buy a different
kind of food instead of pizza. When the price goes up, consumers
usually decide to buy less of that good. They may also buy more of
other goods. This is called the substitution effect. If the price of
pizza goes up, people may start buying tacos instead.

What is the income effect?

Another factor is income, or how much money we make. What
we choose to buy often changes when prices change. This is called
the income effect. When the price of pizza increases, your limited
budget just won’t buy as much as it did in the past. It feels as if you
have less money. When the price of pizza goes up, you spend more
money on pizza but demand less of it. That is the income effect Roast Beef Chili
sandwich
in action. $4.50 $1.99
$5.25
The substitution effect and the income effect both affect demand.
Together, they explain how an increase in prices changes the
quantity demanded.

CheCkpoint What happens to demand when prices increase?

The Substitution Effect
When the price Roast Beef
of one good sandwich Chili
increases, people $4.50 $1.99
have an incentive $5.25
to buy substitutes. The substitution effect
Your decision to also applies when a
purchase a less drop in price creates a
expensive lunch cheaper alternative. Your
is the substitution purchase of the car with
effect in action. the reduced price is
another example of the
substitution effect.

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