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Income Effect of a Price Change

The income effect of a price change states that as the price of a product falls, consumers are financially better off, and when the price of a product rises, consumers are financially worse off. Note that the income effect does not deal with a change in a household's income. Instead, the income effect deals with how a change in a product's price affects the amount of a good or service people are able to purchase.

To illustrate the income effect of a price change, suppose the Jones household typically buys 10 gallons of milk each month at a price of $4 per gallon. Thus, the Jones household's monthly expenditure for milk is $40. If the price of milk fell to $3 per gallon, the household's monthly expenditure for 10 gallons of milk would fall to $30. The Jones household is financially better off due to the drop in the price of milk because the extra $10 can be spent on additional gallons of milk or on other products. If, on the other hand, the price of milk increased from $4 per gallon to $5 per gallon, the Jones household would be financially worse off because it would have to reduce its consumption of milk or some other good or service.

Substitution Effect of a Price Change

The substitution effect of a price change states that if the price of a product falls, consumers will buy more of that product and buy less of a higher-priced substitute good. Conversely, if the price of a product rises, consumers will buy less of it and buy more of a lower-priced substitute.

Consider the Jones household's monthly milk expenditures once again. According to the substitution effect of a price change, a decrease in the price of milk from $4 per gallon to $3 per gallon would likely result in the purchase of additional gallons of milk and the purchase of fewer units of substitute goods such as soft drinks or bottled water. If, on the other hand, the price of milk jumped from $4 per gallon to $5 per gallon, the Jones household would likely respond by purchasing fewer gallons of milk and more units of substitutes such as soft drinks or bottled water.

Consumer Surplus

Consumer surplus is the difference between the price a consumer is willing to pay for an item minus the actual price of the item. Consumer surplus is often viewed as a measure of consumer well-being—the larger the consumer surplus, the greater the consumer's feeling of well-being. When firms such as an auto dealership or department store put merchandise “on sale,” they are, in effect, trying to increase the buyer's consumer surplus and sense of well-being.

Consumer surplus is best illustrated using the demand curve for a product. Consider the demand curve for movie tickets at a local theater, as shown in Figure 4.2. According to this demand curve, at the market price of $10 the movie theater can sell 200 tickets per show. This means that all 200 customers are willing to pay at least $10 for a movie ticket. Yet the

Consumer Surplus for Movie Tickets

Figure 4.2 Consumer Surplus for Movie Tickets

downward sloping demand curve tells us that some of these customers would be willing to pay more than $10 per ticket. Jack, for example, shown at point A on the demand curve, is willing to pay $12.50 for the movie ticket, while James, shown at point B on the demand curve, is willing to pay $15 for the movie ticket. Both Jack and James have to pay only $10 per ticket, however. Hence, by purchasing the $10 movie ticket, Jack enjoys a consumer surplus of $2.50 ($12.50 $10), and James enjoys a consumer surplus of $5 ($15 $10). The shaded area in Figure 4.2 shows the total consumer surplus for buyers of movie tickets in this market. Each ticket buyer in the shaded area, including Jack and James, is willing to pay more than $10 for a ticket.

 
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