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Ten Principles of Economics - Part 47

Ten Principles of Economics - Part 47. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. | CHAPTER 21 THE THEORY OF CONSUMER CHOICE 475 Figure 21-9 A Change in Price. When the price of Pepsi falls the consumer s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum which changes his purchases of both Pepsi and pizza. In this case the quantity of Pepsi consumed rises and the quantity of pizza consumed falls. INCOME AND SUBSTITUTION EFFECTS The impact of a change in the price of a good on consumption can be decomposed into two effects an income effect and a substitution effect. To see what these two effects are consider how our consumer might respond when he learns that the price of Pepsi has fallen. He might reason in the following ways Great news Now that Pepsi is cheaper my income has greater purchasing power. I am in effect richer than I was. Because I am richer I can buy both more Pepsi and more pizza. This is the income effect. Now that the price of Pepsi has fallen I get more pints of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive I should buy less pizza and more Pepsi. This is the substitution effect. Which statement do you find more compelling In fact both of these statements make sense. The decrease in the price of Pepsi makes the consumer better off. If Pepsi and pizza are both normal goods the consumer will want to spread this improvement in his purchasing power over both goods. This income effect tends to make the consumer buy more pizza and more Pepsi. Yet at the same time consumption of Pepsi has become less expensive relative to consumption of pizza. This substitution effect tends to make the consumer choose more Pepsi and less pizza. Now consider the end result of these two effects. The consumer certainly buys more Pepsi because the income and substitution effects both act to raise purchases of Pepsi. But it is ambiguous whether the consumer buys more pizza because the income effect the change in consumption that results when a price change .