What two goods do you consume regularly?
Good 1:
Good 2:
You've selected goods and .
Now set a budget: how much money per week can you devote to these goods?
£ (round to the nearest £)
What is the price of each of these goods? (round to the nearest £)
Price of : £
Price of : £
Summary
You've identified the following:
Your weekly budget: £.
| Good Name | Price | Maximum Consumption |
|---|---|---|
Task:Work out your maximum consumption of both goods if you devote your enitre budget to these goods. (In other words, if you spent your entire budget on just one good, how much would you be able to purchase?)
Once you feel okay with this, click here to move to the next part of the exercise.
Income Effect
Let's consider your consumption of . At the current price, you can consume if you devote your whole budget to this good.
Raise the price to some new value. After the price change, how much of this good can you consume if you devote your whole budget to it?
New Price: £
You can now consume units of .
Notice how this is lower than the units you could have consumed before.
The price of the good went up, and you couldn't afford to buy as much of it, so you bought less of it.
This is known as The Income Effect.
Make notes on this effect, then click here to move to the next part of the exercise.
Substitution Effect
Let's consider your consumption of both and . You can work out opportunity cost of consuming good instead of the other by looking at the prices that you must pay to consume each good:
| Good Name | Price |
|---|---|
Using this information, what is the opportunity cost of ? In other words, how many units of do you have to give up to consume another unit of ?
(Hint: It has to do with prices)
The price of is
The price of is
To gain one unit of , you must give up units of .
Now raise the price of to some new value. After the price change, what will be the opporutnity cost of in terms of ?
New Price: £
To gain one unit of , you must give up units of .
Notice how this is higher than the old opporutnity cost of units of .
Because the opportunity cost of is now higher, we will change our preferences about the consumption of these goods. We will consume fewer units of because it costs us more units of . In other words, even adjusting for income, we will consume fewer units of after its price went up.
This change in preferences is known as The Substitution Effect.
Both The Income Effect and The Substitution Effect explain why we consume less of a product following a rise in its price.
This explains why the demand curve is downward-sloping.
Update your notes on both of these effects.