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The price of haircuts rises to $30. Ogden starts at choice A on the higher opportunity set and the higher indifference curve. After the price of pizza increases, he chooses B on the lower opportunity set and the lower indifference curve. Point B with two haircuts and 10 personal pizzas is immediately below point A with three haircuts and 10 personal pizzas, showing that Ogden reacted to a higher price of haircuts by cutting back only on haircuts, while leaving his consumption of pizza unchanged.

The dashed line in the diagram, and point C, are used to separate the substitution effect and the income effect. To understand their function, start by thinking about the substitution effect with this question: How would Ogden change his consumption if the relative prices of the two goods changed, but this change in relative prices did not affect his utility? The slope of the budget constraint is determined by the relative price of the two goods; thus, the slope of the original budget line is determined by the original relative prices, while the slope of the new budget line is determined by the new relative prices. With this thought in mind, the dashed line is a graphical tool inserted in a specific way: It is inserted so that it is parallel with the new budget constraint, so it reflects the new relative prices, but it is tangent to the original indifference curve, so it reflects the original level of utility or buying power.

Thus, the movement from the original choice (A) to point C is a substitution effect; it shows the choice that Ogden would make if relative prices shifted (as shown by the different slope between the original budget set and the dashed line) but if buying power did not shift (as shown by being tangent to the original indifference curve). The substitution effect will encourage people to shift away from the good which has become relatively more expensive—in Ogden’s case, the haircuts on the vertical axis—and toward the good which has become relatively less expensive—in this case, the pizza on the vertical axis. The two arrows labeled with “s” for “substitution effect,” one on each axis, show the direction of this movement.

The income effect is the movement from point C to B, which shows how Ogden reacts to a reduction in his buying power from the higher indifference curve to the lower indifference curve, but holding constant the relative prices (because the dashed line has the same slope as the new budget constraint). In this case, where the price of one good increases, buying power is reduced, so the income effect means that consumption of both goods should fall (if they are both normal goods, which it is reasonable to assume unless there is reason to believe otherwise). The two arrows labeled with “i” for “income effect,” one on each axis, show the direction of this income effect movement.

Now, put the substitution and income effects together. When the price of pizza increased, Ogden consumed less of it, for two reasons shown in the exhibit: the substitution effect of the higher price led him to consume less and the income effect of the higher price also led him to consume less. However, when the price of pizza increased, Ogden consumed the same quantity of haircuts. The substitution effect of a higher price for pizza meant that haircuts became relatively less expensive (compared to pizza), and this factor, taken alone, would have encouraged Ogden to consume more haircuts. However, the income effect of a higher price for pizza meant that he wished to consume less of both goods, and this factor, taken alone, would have encouraged Ogden to consume fewer haircuts. As shown in [link] , in this particular example the substitution effect and income effect on Ogden’s consumption of haircuts are offsetting—so he ends up consuming the same quantity of haircuts after the price increase for pizza as before.

Questions & Answers

how environment affect demand and supply of commodity ?
Amos Reply
Wht at the criteria for market ?
what is difference between monitory policy and fiscal policy?
Malik Reply
monetary policy is a policy thrust by National Govt(CBN) to influence government spending, purchase &taxes
necessity of economics
Pamela Reply
I will say want,choice,opportunity cost,scarcity,scale of preference
what is monopoly market.How price output are determined under monopoly market
b) Monopoly market is an impecfect market where s single firm having the innovation to produce a particular commodity.Prices are determined through output since there are no other competitive.
Monopoly market:firm has market power & does not respond to market price
Explain the process of price determination under perfect competition market with suitable diagram
bisham Reply
Price determination under perfect competition via this process :firms have no market power to influence price rather firms respond to market price.
price is different from demand- demand is amount of commodity
Effah Reply
demand is amount /quantity of commodity a potential buyer is willing to buy at a given price at market
demand is a desire of customer on commodity with the ability to pay it and willing to buy it at given price of commodity
demand is price of what
Faith Reply
show that shortrun average cost
Baby Reply
what is economics
Mbah Reply
what is money
what is money
Difine macro economics
money is a medium of exchange between goods and services,maybe inform of currency.
Economics is study of how human beings strive to satisfy numerous wants using limited available resources.
how do you find the maximum number of workers the firms should employ order to produce where there are increasing returns
what are implications of computing national income?.
what is the formulae for calculating national income
it calculated by value added method
classify the production units like agriculture, banking, transport etc
money is anything that is generally acceptetable for human
Estimate the net value added(NVA) at fixed cost by each industrial structure
definition of unemployment
Adam Reply
what are the causes of unemployment?
Mbubi Reply
The main causes of unemployment are listed below. 1. Frictional unemployment 2. Cyclical unemployment 3. Structural unemployment
We can also categorize the causes on a broader sense as: 1. Political and 2. Social cause As unemployeement root causes are embaded in this two.
would opportunity cost exist if there was no scarcity?
yes just because the opportunity cost arose when there is Alternative to choose among the alternatives.
I am thinking that, if our resources were unlimited, then there wouldn't be any need to forgo some wants. Hence the inexistence if opportunity cost
politics has done what?
consider time assani
I'm Emmanuel,...I taught the main cause is the change in gov't.
...Lack of capital to set up a firm respectively
I would like to bring in Educational levels can also be the cause the cause of the problem respectively
lack of skills among the new generation is the serious issue.
Where I come from , I don't see why education or personal aspects seem to do with unimployment, technically the motivation and eigerness in all works of live is there , dispite the cultural influence and physical bearriors;the thing we lacking is Government Support and open market ethics.
sorry about that-(repation). We have a over powering ethical political system that's displacing the marketing asspects of economy and causing large scale unemployment right across the board...
can someone Explain Expansionary Monetary Policy and Contractionary Monetary Policy Using one of the instrument of Monetary Policy? Please am kinda lost here?. ta
Emmanuel Reply
using a graph show the case of substitute and compliment goods
Ade Reply
can anyone give me a simple explanation to Five Sector Macroeconomics?
Can someone please define what economics is
jason Reply
economics simply is a social science subject that study human behavior.
economics is a social science which studies human behaviour as a relationship between ends and scarce means that has alternative uses
Can someone please tell me how to calculate GDP
emmanual kapal to calculate GDP (Gross Domestic Product) has three method in calculating it (1)income approach (2) expenditure approach (3) value added method
thanks Alae
u are welcome
in basic terms economics is revered to as battery system, it date back to when Men sees the need to exchange sapless goods and produce to gain , either wealth , basic necessities or to establish trading ties for personal benefit or social asspects in terms of coexistence and continuity, future .
what is the law of demand
Berlinda Reply
keep other thing constant, when the price increases demand decrease when the price decreases demand increases of the commodity.
all things being equal,quantity demanded decrease as price increase and increase as price decrease
there's practial joke to it ..." the higher the demand ; scarcity, increase in production and drop in quality"... quite the controversy - for example China vs Europe, United States and we are all boxed up in between somewhere...
Other thing remain constant the low price of commodity the high quantity of commodity and vice versa is true
Explain Effective demand
Anita Reply
What is effective demand
like Modi is in demand...best example of effective demand
Don't get you
Anita you mean you don't get me or who?
level of demand that represents a real intention to purchase by people with the means to pay
Difference between extinct and extici spicies
Amanpreet Reply
in a comparison of the stages of meiosis to the stage of mitosis, which stages are unique to meiosis and which stages have the same event in botg meiosis and mitosis
Leah Reply
Equilibrium price is a stable price and it must stay.discuss
Elvis Reply
Card 14 / 21: What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?
Ali Reply

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Source:  OpenStax, Principles of macroeconomics for ap® courses. OpenStax CNX. Aug 24, 2015 Download for free at http://legacy.cnx.org/content/col11864/1.2
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