Lecture 08

INCOME AND SUBSTITUTION EFFECTS
THE INCOME EFFECT

CHAPTER 6: Household Behavior and
Consumer Choice
When the price of something

we buy falls, we are better
off. When the price of
something we buy rises, we
are worse off.
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
THE SUBSTITUTION EFFECT

Consumer Choice
When the price of something falls, ceteris paribus, we are better

off, and we are likely to buy more of that good and other goods
(income effect). Because lower price also means “less expensive
relative to substitutes,” we are likely to buy more of the good
(substitution effect).
When the price of something rises, we are worse off, and we will
buy less of it (income effect). Higher price also means “more
expensive relative to substitutes,” and we are likely to buy less of
it and more of other goods (substitution effect).
Both the income and the substitution effects imply a negative

relationship between price and quantity demanded—in other
words, downward-sloping demand.
Consumer Choice
FIGURE 6.7 Income and Substitution Effects of a Price Change
HOUSEHOLD CHOICE IN INPUT MARKETS
THE LABOR SUPPLY DECISION

As in output markets, households face constrained choices

Consumer Choice
in input markets. They must decide
1. Whether to work
2. How much to work
3. What kind of a job to work at
In essence, household members must decide how much

labor to supply. The choices they make are affected by
1. Availability of jobs
2. Market wage rates
3. Skills they possess
Consumer Choice
FIGURE 6.9 The Trade-Off Facing Households
The wage rate can be thought of as the price—or the opportunity cost—of the benefits of
either unpaid work or leisure.
THE PRICE OF LEISURE

Consumer Choice
Trading off one good for another involves buying less of

one and more of another, so households simply reallocate
money from one good to the other. “Buying” more leisure,
however, means reallocating time between work and
nonwork activities. For each hour of leisure that I decide
to consume, I give up one hour’s wages. Thus the wage
rate is the price of leisure.
INCOME AND SUBSTITUTION EFFECTS OF A

WAGE CHANGE
Consumer Choice
labor supply curve A diagram that shows the

quantity of labor supplied at different wage rates. Its
shape depends on how households react to changes
in
the wage rate.
Income and substitution effects
There are two effects that determine supply of labour:
The substitution effect states that a higher wage

Consumer Choice
makes work more attractive than leisure (i.e. price of

leisure seems to go up). Therefore, in response to
higher wages, supply increases because work gives
greater remuneration.
The income effect states that a higher wage means

workers can achieve a target income by working fewer
hours. Or that workers are satisfied with the income
and now considers leisure important as well. Therefore,
if wages increase, it becomes easier to get enough
income through working fewer hours.
A typical supply curve
shows an increase in
supply as wages rise. It

slopes from left to right.
Consumer Choice
However, in labour
markets, we often
witness a backward
bending supply curve.
This means after a
certain point; higher
wages can lead to a
decline in labour supply.
This occurs when higher
wages encourage
workers to work less and
enjoy more leisure time.
REVIEW TERMS AND CONCEPTS
law of diminishing marginal utility

marginal utility (MU)
Consumer Choice
substitution effect of a price change

total utility
utility
utility-maximizing rule
budget constraint
income effect of a price change
labor supply curve
Chapter
7
The Production Process:
The Behavior of
Profit-Maximizing Firms
7
CHAPTER 7: The Production Process: The Behavior
The Production Process:

of Profit-Maximizing Firms
The Behavior of
Chapter Outline
Profit-Maximizing Firms
The Behavior of Profit-
Maximizing Firms
Profits and Economic Costs
Short-Run versus Long-Run
Decisions
The Bases of Decisions: Market
Price of Outputs, Available
Technology, and Input Prices
The Production Process

Production Functions: Total
Product, Marginal Product, and
Average Product
Production Functions with Two
Variable Factors of Production
Choice of Technology
Looking Ahead: Cost and Supply
Appendix: Isoquants and Isocosts
THE PRODUCTION PROCESS: THE BEHAVIOR
OF PROFIT-MAXIMIZING FIRMS
All firms, whether competitive or not, demand inputs, engage

in production, and produce outputs. All firms have an

incentive to maximize profits and thus to minimize costs.
production The process by which inputs

are combined, transformed, and turned
into outputs.
firm An organization that comes into

being when a person or a group of
people decides to produce a good or
service to meet a perceived demand.
Most firms exist to make a profit.
Perfect Competition
perfect competition An industry structure in

which there are many firms, each small relative
to the industry, producing virtually identical
products and in which no firm is large enough to
have any control over prices. In perfectly
competitive industries, new competitors can
freely enter and exit the market.
homogeneous products Undifferentiated

products; products that are identical to, or
indistinguishable from, one another.
FIGURE 7.2 Demand Facing a Single Firm in a Perfectly Competitive Market
THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS
All firms must make several basic decisions to achieve what

we assume to be their primary objective—maximum profits.
1. 2. 3.
How much Which production How much of
output to technology each input to
supply to use demand
FIGURE 7.3 The Three Decisions That All Firms Must Make

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INCOME AND SUBSTITUTION EFFECTS

THE INCOME EFFECT

When the price of something

THE SUBSTITUTION EFFECT

When the price of something falls, ceteris paribus, we are better

Both the income and the substitution effects imply a negative

FIGURE 6.7 Income and Substitution Effects of a Price Change

THE LABOR SUPPLY DECISION

As in output markets, households face constrained choices

in input markets. They must decide

In essence, household members must decide how much

FIGURE 6.9 The Trade-Off Facing Households

THE PRICE OF LEISURE

Trading off one good for another involves buying less of

INCOME AND SUBSTITUTION EFFECTS OF A

labor supply curve A diagram that shows the

Income and substitution effects

The substitution effect states that a higher wage

makes work more attractive than leisure (i.e. price of

The income effect states that a higher wage means

supply as wages rise. It

law of diminishing marginal utility

substitution effect of a price change

The Production Process:

The Production Process

Looking Ahead: Cost and Supply

Appendix: Isoquants and Isocosts

All firms, whether competitive or not, demand inputs, engage

in production, and produce outputs. All firms have an

production The process by which inputs

firm An organization that comes into

perfect competition An industry structure in

homogeneous products Undifferentiated

FIGURE 7.2 Demand Facing a Single Firm in a Perfectly Competitive Market

All firms must make several basic decisions to achieve what

we assume to be their primary objective—maximum profits.

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