How can the income and substitution effects of a price change help explain this
Recent research confirms that the demand for cigarettes is not only price inelastic, but it also indicates smokers with incomes in the lower half of all incomes respond to a given price increase by reducing their purchases by amounts that are more than four times as large as the purchase reductions made by smokers in the upper half of all incomes.
How can the income and substitution effects of a price change help explain this?
Review price elasticity of demand and supply. Price elasticity describes the sensitivity between quantity demanded/supplied and price when a change in price occurs. A relatively lower change in quantity versus a change in price means the product is more price inelastic; a higher relative change in quantity versus a price change indicates more price elastic. Review the substitution effect and income effect dynamics.
Recent research confirms that the demand for cigarettes is not only price inelastic, but it also indicates smokers with incomes in the lower half of all incomes respond to a given price increase by reducing their purchases by amounts that are more than four times as large as the purchase reductions made by smokers in the upper half of all incomes.
How can the income and substitution effects of a price change help explain this?
Review price elasticity of demand and supply. Price elasticity describes the sensitivity between quantity demanded/supplied and price when a change in price occurs. A relatively lower change in quantity versus a change in price means the product is more price inelastic; a higher relative change in quantity versus a price change indicates more price elastic. Review the substitution effect and income effect dynamics.
Microeconomics-Lecture 2
Price Elasticity
Price elasticity of demand and supply help us understand the relative sensitivity quantity has based upon a change in price. So, if price rises or falls by 1%, what will the effect be on quantity demanded and/or quantity supplied? If, for example, a good’s price rises 1% and quantity demanded falls by 10%, we can say the sensitivity of quantity demanded is quite high for this good. If, on the other hand, a 1% rise in price leads to a fall in quantity demanded of .5%, we can then say the sensitivity of quantity demanded in this case is quite low to a price change. In the first scenario when quantity demanded falls at a higher rate than the price is rising, that good is considered to be relatively highly price elastic; in the second scenario when quantity demanded falls at a slower pace than price, that good is considered to be price inelastic.
When graphing, the slope of the curve, whether demand or supply, will be steep if it is price inelastic. The more horizontal and flatter the curve, the more price elastic it is.Another way to look at it is price sensitivity is low when the slope is relatively high and the steepness of the curve is relatively significant, since quantity demanded/supplied doesn’t fall as much relative to price, indicating a product highly desired or needed. On the other hand, price sensitivity is high when the slope is relatively low and flat, since quantity demanded/supplied falls more significantly than price rises.
Firms attempt to maximize total revenues at all times, pricing at the midpoint of their demand curve. This is especially true for firms with a downward sloping demand curve. A price below the midpoint will indicate price inelasticity exists, and so raising price will not hurt total revenues, but actually total revenues will rise – only up until the midpoint of the demand curve. On the other hand, a price above the midpoint will indicate price elasticity exists, and so raising price beyond the midpoint above will result in lower total revenues.
In summary, it is critical to understand price elasticity of demand and supply to fully comprehend the sensitivity price has on quantity. For consumers, goods that are more highly price inelastic in demand or supply can be more costly since quantity demanded/supplied changes less than the change in price. For producers or sellers, goods that are more highly price inelastic can mean more market pricing power. Other measures of price elasticity are cross-price elasticity of demand, which is the effect of a change in price of one good to the quantity demanded of a substitute or other good, and income elasticity of demand, which is the effect income changes have on quantity demanded of a good.
Utility
How does the satisfaction and usefulness of consuming a product get measured?
Does consuming ever increasing amounts of something mean necessarily more satisfaction?
In economics, we measure the satisfaction and/or usefulness derived from the consumption of a product in units of utility, or utils.
Specifically, utility is the want-satisfying power that one gets out of consuming a product, but the more something is consumed, there are diminishing returns and diminishing marginal utility.
When deciding what generates the most utility, one must analyze the effect consuming one more unit has on the consumer of the product based upon the marginal utility of that good and its price.
Consumer equilibrium will be achieved when the marginal utility of A divided by the price of good A equals the marginal utility of B divided by the price of good B equals the marginal utility of Z divided by the price of good Z. Total utility is not going to be increased when more budget dollars are allocated to one good versus another. Thus, diminishing marginal utility conforms to the law of demand since by consuming more of a product, the marginal utility curve is downward sloping.
Coinciding with utility and marginal utility, consumers will substitute products based upon income and the prices of other goods.
Thus, if two products are similar and substitutes for each other in the eyes of consumers, a rise in price in one will lead to the substitution of that product to the other product which has not risen or risen as much. That is the substitution effect.
Similarly, when one’s income rises or falls, that will bring about changes in consumption of certain products. For example, if one’s income rises, some products will not be demanded as much, while others will.
A specific example of this concept of the income effect is an inferior good, such as hamburger. As one earns more money, inferior goods like hamburger are consumed less, and normal goods, like ground sirloin, are consumer more. Greater marginal utility is found in normal goods.
In summary, utility is the want-satisfying power one gets from consuming a product. We measure utility in units of utility, called utils. As we consume more of a product, total utility is achieved, but diminishing marginal utility occurs.
That diminishing marginal utility effect is described in the law of demand and the downward-sloping curve. Consumer equilibrium is achieved when the marginal utility of good A divided by the price of good A equals the marginal utility of good Z divided by the price of good Z.
And lastly, based upon the number of substitutes and income, consumers will substitute one good for another, particularly when the price of one rises in relation to another; that is the substitution effect. As one earns more income, inferior goods will be consumed less, and normal goods will be consumed more.
Answer preview How can the income and substitution effects of a price change help explain this
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