5.3 How Changes in Income and Prices Affect Consumption Choices
Learning Objectives
By the end of this section, you will be able to:
- Explain how income, prices, and preferences affect consumer choices
- Contrast the substitution effect and the income effect
- Utilize concepts of demand to analyze consumer choices
- Apply utility-maximizing choices to governments and businesses
Just as we can use utility and marginal utility to discuss making consumer choices along a budget constraint, we can also use these ideas to think about how consumer choices change when the budget constraint shifts in response to changes in income or price. Because we can use the budget constraint framework to analyze how quantities demanded change because of price movements, the budget constraint model can illustrate the underlying logic behind demand curves.
How Changes in Income Affect Consumer Choices
Let’s begin with a concrete example illustrating how changes in income level affect consumer choices. Figure 5.4 shows a budget constraint that represents Kimberly’s choice between concert tickets at $50 each and getting away overnight to a bed-and-breakfast for $200 per night. Kimberly has $1,000 per year to spend between these two choices. After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products, Kimberly chooses point (M), with eight concerts and three overnight getaways as her utility-maximizing choice.
Now, assume that the income Kimberly has to spend on these two items rises to $2,000 per year, causing her budget constraint to shift out to the right. How does this rise in income alter her utility-maximizing choice? Kimberly will again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her utility-maximizing choice on the new budget line, but how will her new choice relate to her original choice?
We can replace the possible choices along the new budget constraint into three groups, which the dashed horizontal and vertical lines that pass through the original choice (M) in the figure divide. All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line, like choice (P) with two overnight stays and 32 concert tickets, involve less of the good on the horizontal axis but much more of the good on the vertical axis. All choices to the right of the vertical dashed line and above the horizontal dashed line—like choice (N) with five overnight getaways and 20 concert tickets—have more consumption of both goods. Finally, all choices that are to the right of the vertical dashed line but below the horizontal dashed line, like choice (Q) with four concerts and nine overnight getaways, involve less of the good on the vertical axis but much more of the good on the horizontal axis.
All of these choices are theoretically possible, depending on Kimberly’s personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods. When income rises, the most common reaction is to purchase more of both goods, like choice (N), which is to the upper right relative to Kimberly’s original choice (M), although exactly how much more of each good will vary according to personal taste. Conversely, when income falls, the most typical reaction is to purchase less of both goods. As we defined in the chapter on Demand and Supply and again in the chapter on Elasticity, we call goods and services normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity consumed.
However, depending on Kimberly’s preferences, a rise in income could cause consumption of one good to increase while consumption of the other good declines. A choice like (P) means that a rise in income caused her consumed quantity overnight stays to decline, while a choice like point (Q) would mean that a rise in income caused her quantity of concerts to decline. Goods where demand declines as income rises (or conversely, where the demand rises as income falls) are called “inferior goods.” An inferior good exists when people trim back on a good as income rises, because they can now afford the more expensive choices that they prefer. For example, a higher-income household might eat fewer hamburgers or be less likely to buy a used car, and instead eat more steak and buy a new car.
How Price Changes Affect Consumer Choices
For analyzing the possible effect of a change in price on consumption, let’s again use a concrete example. Figure 5.5 represents Sergei’s consumer choice, between purchasing baseball bats and cameras. A price increase for baseball bats would have no effect on the ability to purchase cameras, but it would reduce the number of bats Sergei could afford to buy. Thus, a price increase for baseball bats, the good on the horizontal axis, causes the budget constraint to rotate inward, as if on a hinge, from the vertical axis. As in the previous section, the point labeled (M) represents the originally preferred point on the original budget constraint, which Sergei has chosen after contemplating his total utility and marginal utility and the trade-offs involved along the budget constraint. In this example, the units along the horizontal and vertical axes are not numbered, so the discussion must focus on whether Sergei will consume more or less of certain goods, not on numerical amounts.
After the price increase, Sergei will make a choice along the new budget constraint. Again, we can divide his choices into three segments by the dashed vertical and horizontal lines. In the upper left portion of the new budget constraint, at a choice like (H), Sergei consumes more cameras and fewer bats. In the central portion of the new budget constraint, at a choice like (J), he consumes less of both goods. At the right-hand end, at a choice like (L), he consumes more bats but fewer cameras.
The typical response to higher prices is that a person chooses to consume fewer products with the higher price. This occurs for two reasons, and both effects can occur simultaneously. The substitution effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price. The income effect is that a higher price means, in effect, the buying power of income has been reduced (even though actual income has not changed), which leads to buying less of the good (when the good is normal). In this example, the higher price for baseball bats would cause Sergei to buy fewer bats for both reasons. Exactly how much will a higher price for bats cause Sergei’s bat consumption to fall? Figure 5.5 suggests a range of possibilities. Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats, but cutting his camera consumption. This choice is the point (K) on the new budget constraint, straight below the original choice (M). Alternatively, Sergei might react by dramatically reducing his bat purchases and instead buy more cameras.
What is important to remember is that changing the price of a product will not only affect the quantity purchased of that product. Instead, changing the price of a product can also affect (either negatively or positively) the quantity of other products consumed.
In short, a higher price typically causes reduced consumption of the good in question, but it can affect the consumption of other goods as well.
LINK IT UP
Read Digiday’s article titled Pressured by Amazon, retailers are experimenting with dynamic pricing that discusses variable prices on Amazon.
The Foundations of Demand Curves
Changes in the price of a good lead the budget constraint to rotate. A rotation in the budget constraint means that when individuals are seeking their highest utility, the quantity that is demanded of that good will change. In this way, the logical foundations of demand curves—which show a connection between prices and quantity demanded—are based on the underlying idea of individuals seeking utility. Figure 5.5 (a) shows a budget constraint with a choice between housing and “everything else.” (Putting “everything else” on the vertical axis can be a useful approach in some cases, especially when the focus of the analysis is on one particular good.) We label the preferred choice on the original budget constraint that provides the highest possible utility M0. The other three budget constraints represent successively higher prices for housing of P1, P2, and P3. As the budget constraint rotates in, and in, and in again, we label the utility-maximizing choices M1, M2, and M3, and the quantity demanded of housing falls from Q0 to Q1 to Q2 to Q3.
Thus, as the price of housing rises, the budget constraint rotates outwards and the quantity consumed of housing falls, ceteris paribus. We graph this relationship—the price of housing rising from P0 to P1 to P2 to P3, while the quantity of housing demanded falls from (Q0) to (Q1) to (Q2) to (Q3)—on the demand curve in Figure 5.6 (b). The vertical dashed lines stretching between the top and bottom of Figure 5.6 show that the quantity of housing demanded at each point is the same in both (a) and (b). We ultimately determine the shape of a demand curve by the underlying choices about maximizing utility subject to a budget constraint. While economists may not be able to measure “utils,” they can certainly measure price and quantity demanded.
Applications in Government and Business
The budget constraint framework for making utility-maximizing choices offers a reminder that people can react to a change in price or income in a range of different ways. For example, in the winter months of 2005, costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared, due in large part to the disruption caused by Hurricanes Katrina and Rita. Some people reacted by reducing the quantity demanded of energy; for example, by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside. Even so, many home heating bills rose, so people adjusted their consumption in other ways. As you learned in the chapter on Elasticity, the demand for home heating is generally inelastic. Each household cut back on what it valued least on the margin. For some it might have been some dinners out, or a vacation, or postponing buying a new refrigerator or a new car. Sharply higher energy prices can have effects beyond the energy market, leading to a widespread reduction in purchasing throughout the rest of the economy.
A similar issue arises when the government imposes taxes on certain products, such as on gasoline, cigarettes, and alcohol. Say that a tax on alcohol leads to a higher price at the liquor store. The higher price of alcohol causes the budget constraint to pivot left, and alcoholic beverage consumption is likely to decrease. However, people may also react to the higher price of alcoholic beverages by cutting back on other purchases. For example, they might cut back on snacks at restaurants like chicken wings and nachos. It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages. Read the next Clear It Up to learn about how who controls the household income influences buying decisions.
The Unifying Power of the Utility-Maximizing Budget Set Framework
An interaction between prices, budget constraints, and personal preferences determine household choices. The flexible and powerful terminology of utility-maximizing gives economists a vocabulary for bringing these elements together.
Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall, accept a job, or make a deposit in a savings account. However, economists do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another. If we accept these assumptions, then the idea of utility-maximizing households facing budget constraints becomes highly plausible.
CLEAR IT UP
Does who controls household income make a difference?
In the mid-1970s, the United Kingdom made an interesting policy change in its “child allowance” policy. This program provides a fixed amount of money per child to every family, regardless of family income. The child allowance had traditionally been distributed to families by withholding less in taxes from the paycheck of the family wage earner—typically the father during this era. The new policy instead provided the child allowance as a cash payment to the mother. As a result of this change, households have the same level of income and face the same prices in the market, but the money is more likely to be in the mother’s purse than in the father’s wallet.
Should this change in policy alter household consumption patterns? Basic models of consumption decisions, of the sort that we examined in this chapter, assume that it does not matter whether the mother or the father receives the money, because both parents seek to maximize the family’s utility as a whole. In effect, this model assumes that everyone in the family has the same preferences.
In reality, the share that the father or mother controls does affect what the household consumes. When the mother controls a larger share of family income a number of studies, in the United Kingdom and in a wide variety of other countries, have found that the family tends to spend more on restaurant meals, child care, and women’s clothing, and less on alcohol and tobacco. As the mother controls a larger share of household resources, children’s health improves, too. These findings suggest that when providing assistance to poor families, in high-income countries and low-income countries alike, the monetary amount of assistance is not all that matters: it also matters which family member actually receives the money.
The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price, not just effects on the one product that might seem most immediately affected.
BRING IT HOME
“Eeny, Meeny, Miney, Moe”—Making Choices
In what category did consumers worldwide increase their spending during the Great Recession? Higher education. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), enrollment in colleges and universities rose one-third in China and almost two-thirds in Saudi Arabia, nearly doubled in Pakistan, tripled in Uganda, and surged by three million—18 percent—in the United States. Why were consumers willing to spend on education during lean times? Both individuals and countries view higher education as the way to prosperity. Many feel that increased earnings are a significant benefit of attending college.
U.S. Bureau of Labor Statistics data from March 2018 supports this view, as Figure 5.7 indicates. Statistics show a positive correlation between earnings and education. The data also indicate that unemployment rates fall with higher levels of education and training.
Why spend the money to go to college during recession? Because if you are unemployed (or underemployed, working fewer hours than you would like), the opportunity cost of your time is low. If you’re unemployed, you don’t have to give up work hours and income by going to college.
SELF-CHECK QUESTIONS
- Explain all the reasons why a decrease in a product’s price would lead to an increase in purchases.
- As a college student you work at a part-time job, but your parents also send you a monthly “allowance.” Suppose one month your parents forgot to send the check. Show graphically how your budget constraint is affected. Assuming you only buy normal goods, what would happen to your purchases of goods?