Demand Curves and Income/Substitution Effects

Jonathan Gruber proceeds to discuss the concept of elasticity of demand, defining it as the percentage change in quantity demanded divided by the percentage change in price. He explains that elasticity of demand is typically negative or zero because as price increases, quantity demanded decreases. Gruber also addresses a student's question regarding whether the change in quantity should be measured over the new or old quantity, explaining that in discrete analysis, it's measured using the old quantity.

Gruber then explores the extremes of elasticity of demand, starting with perfectly inelastic demand, where the quantity demanded remains constant regardless of price changes. He gives examples such as insulin, where there are no substitutes, leading to perfectly inelastic demand. He also discusses the concept of perfectly elastic demand, where any deviation from a fixed price leads to losing the entire market share due to perfect substitutes.

The discussion continues with Gruber emphasizing that in reality, goods fall within a range between perfectly elastic and perfectly inelastic demand, and the key determinant of elasticity is substitutability. Goods with more substitutes are more elastically demanded.

Transitioning to the effect of changes in income on demand curves, Gruber presents Figure 4-4, where he demonstrates how an increase in income leads to increased quantities demanded of both pizza and cookies, while a decrease in income leads to decreased quantities demanded of both goods. He illustrates how changes in income affect consumer choices and traces out the relationship between income changes and demand for cookies.

Jonathan Gruber continues his lecture by introducing the concept of Engel curves, which represent the relationship between income and quantity demanded. He explains that Engel curves can be linear, but in reality, they may not be constant elasticity curves due to the linear representation. Gruber acknowledges that this is a simplification used for teaching purposes.

He then discusses the income elasticity of demand (denoted by gamma), which measures the responsiveness of quantity demanded to changes in income. Gruber highlights that goods with a positive income elasticity are called normal goods, while those with a negative income elasticity are considered inferior goods. He provides examples such as fast food as an inferior good and luxury items like watches as normal goods.

Furthermore, Gruber distinguishes between luxury goods, where the proportion of spending increases as income rises (gamma > 1), and necessities, where the proportion of spending increases but at a slower rate (gamma < 1). He explains that this distinction is based on how spending changes proportionally with income.

Transitioning to the effects of price changes on consumer behavior, Gruber introduces the concepts of substitution effect and income effect. The substitution effect refers to the change in quantity demanded of a good when its price changes while holding utility constant. The income effect, on the other hand, refers to the change in quantity demanded of a good as income changes, considering the initial level of income.

Gruber then presents Figure 4-5 to illustrate the decomposition of the response to a price change into the substitution effect and income effect using a budget constraint diagram. He explains how the initial tangency point between the budget constraint and the indifference curve represents the optimal consumption bundle, considering both price and income. Jonathan Gruber continues his lecture by analyzing the effects of a price change on consumer behavior using the example of cookies and pizza. He discusses how a rise in the price of cookies from $6 to $9 would lead to a reduction in the quantity demanded of cookies from 6 to 4. Gruber explains that this change can be decomposed into two effects: the substitution effect and the income effect. The substitution effect is defined as the change in quantity demanded of a good when its price changes while holding utility constant. Gruber illustrates this graphically by showing how an imaginary budget constraint (bc prime) with the new price ratio but tangent to the old indifference curve represents the compensated demand. He emphasizes that the substitution effect is always negative because consumers adjust their consumption to move away from the more expensive good. Gruber then introduces the income effect, which refers to the change in quantity demanded of a good as income changes, holding prices constant. He explains that the income effect can either increase or decrease the quantity demanded of a good, depending on whether it is a normal or inferior good. In the case of an inferior good, such as fast food, a rise in the price of cookies would make consumers effectively poorer, leading to an increase in the quantity demanded of cookies due to the income effect. Furthermore, Gruber presents a new example involving the choice between steak and potatoes to demonstrate how the income and substitution effects can work against each other. He explains that while the substitution effect decreases the quantity demanded of potatoes from 7.5 to 4 due to the price increase, the income effect increases the quantity demanded of potatoes from 4 to 5 because potatoes are considered an inferior good. Overall, the net effect is still a reduction in the quantity demanded of potatoes, but the opposing directions of the two effects highlight the importance of understanding consumer behavior in response to price changes. Jonathan Gruber concludes his lecture by discussing the implications of the income and substitution effects on consumer behavior, particularly in the case of inferior goods. He presents a table outlining the effects of price changes on demand for normal and inferior goods, emphasizing that while normal goods exhibit clear responses to price changes, the response to price changes for inferior goods is more complex due to the opposing directions of the income and substitution effects. Gruber introduces the concept of Giffen goods, which are goods for which the income effect dominates the substitution effect, resulting in an upward-sloping demand curve. He notes that while examples of Giffen goods are rare in reality, there have been studies, such as one conducted in China, that provide some evidence of their existence. In the study, very poor households exhibited an upward-sloping demand curve for rice when given discounts on its price, suggesting that for extremely impoverished individuals, rice could function as a Giffen good. Gruber acknowledges that while downward-sloping demand curves are typical in demand analysis, in certain contexts, the interplay between income and substitution effects can lead to unconventional demand curves. He suggests that exploring these phenomena will be a focus of future discussions in the course.