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Econ 4010 Lecture 5

# Econ 4010 Lecture 5 - 4 Individual and Market...

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<Lecture 5> 4. Individual and Market Demand Substitutes and Complements Prices of related goods also influence how much of a product people buy. Goods that are substitutes satisfy the same set of preferences. An example of a substitute for hamburger is pork. If pork prices are high, people are tempted to shift away from pork to hamburger, and if pork prices are low, people are tempted to shift from hamburger to pork. The opposite of a substitute is a complement, a good that helps complete another in some way. Ketchup and hamburger buns are complements to hamburger, and if they are priced low enough, consumption of hamburger may rise. Sometimes goods are such good complements that they are sold together and we think of them as a single item. Left shoes and right shoes are an example. Q1. Suppose that a consumer spends a fixed amount of income per month on the following pairs of goods. If the price of the first goods increases, explain the effect on the demand quantity of each of the goods. In each pair, which are likely to be complements and which are likely to be substitutes? a. Tortilla chips and salsa If the price of tortilla chips increases, the demand for both goods will fall, assuming they are complements. b. Tortilla chips and potato chips If the price of tortilla chips increases, the demand for tortilla chips will fall and the demand for potato chips will rise, assuming they substitutes. c. Movie tickets and gourmet coffee If the price of movie tickets increases, the demand for movie tickets will fall and the demand for coffee is unchanged, assuming they are unrelated. d. Travel by bus and travel by subway If the price of bus travel increases, the demand for bus tickets will fall and the demand for subway tickets will rise, assuming they are substitutes. Income and Substitution Effects (p.116) A fall in the price of a good has two effects: 1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. Q2. Explain the difference between an income effect and a substitution effect The substitution effect measures the effect of a change in the price of a good on the consumption of the good, utility held constant. The income effect measures the effect of a change in purchasing power (caused by a change in the price of a good) on the consumption of the good, relative prices held constant. 1

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Income Effect: As the price of a good increases, the money a person has left over is reduced. This is the same as saying that real income fall as prices rise. For example, assume someone has a fixed income of 120 dollars a week. If the price of a bottle of wine is 10 dollars they can buy 12 bottles. If the price doubles to 20 dollars now they can only afford 6 bottles. If the price were 30 dollars, only 4 bottles could be bought. So as the price of wine increases, the ability to afford them falls. Notice that income in the example is fixed, it does not change.
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Econ 4010 Lecture 5 - 4 Individual and Market...

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