Price Elasticity of Supply and Demand

Price Elasticity of Demand is a measure of the relationship between a change in the

quantity demanded of a particular good and a change in its price. Price elasticity of demand
is a term in economics often used when discussing price sensitivity. Thus it is defined as
simply as the ratio of the percentage of change in quantity demanded to the percentage
change in price. The formula for calculating price elasticity of demand is:


Price Elasticity of Demand = % change in quantity demanded
% change in price


Price elasticity of demand measures the responsiveness of demand to changes in price for a
particular good.
Types of Elasticity
If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e., demand
does not change when price changes). Values between zero and one indicate that demand is
inelastic (this occurs when the percent change in demand is less than the percent change in
price). When price elasticity of demand equals one, demand is unit elastic (the percent
change in demand is equal to the percent change in price). Finally, if the value is greater
than one, demand is perfectly elastic (demand is affected to a greater degree by changes in
price).

For example, if the quantity demanded for a good increases 15% in response to a 10%
increase in price, the price elasticity of demand would be 15% / 10% = 1.5. The degree to
which the quantity demanded for a good changes in response to a change in price can be
influenced by a number of factors. Factors include the number of close substitutes (demand
is more elastic if there are close substitutes) and whether the good is a necessity or luxury
(necessities tend to have inelastic demand while luxuries are more elastic). A special case is
unitary elasticity. It is a demand relationship in which the percentage change in quantity of
a product demanded is the same as the percentage change in price in absolute value (a
demand elasticity of -1).
Businesses evaluate price elasticity of demand for various products to help predict the
impact of a pricing on product sales. Typically, businesses charge higher prices if demand
for the product is price inelastic.
If a small change in price is accompanied by a large change in quantity demanded, the
product is said to be elastic (or responsive to price changes). Conversely, a product is
inelastic if a large change in price is accompanied by a small amount of change in quantity
demanded.
http://www.investopedia.com/terms/p/priceelasticity.asp




Calculating Percentage Changes


Because we need to know percentage changes to calculate elasticity, let us begin our
example by calculating the percentage change in quantity demanded. An example
(Figure5.1 a) is that the quantity of steak demanded increases from 5 pounds (Q1) to 10
pounds (Q2) when price drops from $3 to$2 per pound. Thus, the change in quantity
demanded is equal to Q2 - Q1, or 5 pounds. To convert this change into a percentage
change, we must decide on a base against which to calculate the percentage. It is often
convenient to use the initial value of quantity demanded (Q1) as the base. To calculate
percentage change in quantity demanded using the initial value as the base, the
following formula is used:

From the data in Figure 5.1 a, Q2 = 10 and Q1 = 5. Thus,

Expressing this equation verbally, we can say that an increase in quantity demanded from
5 pounds to 10 pounds is a 100 percent increase from 5 pounds. Note that you arrive at
exactly the same result if you use the diagram in Figure 5.1(b), in which quantity
demanded is measured in ounces. An increase from Q1 (80 ounces) to Q2 (160 ounces) is a
100 percent increase. We can calculate the percentage change in price in a similar way.
Once again, let us use the initial value of Pthat is, P1as the base for calculating the
percentage. By using P1 as the base, the formula for calculating the percentage of change in
P is:



In Figure 5.1(a), P2 equals 2 and P1 equals 3. Thus, the change in P, or P, is a negative
number: P2 - P1 = 2 - 3 = -1. This is true because the change is a decrease in price. Plugging
the values of P1 and P2 into the preceding equation, we get

In other words, decreasing the price from $3 to $2 is a 33.3 percent decline.
Elasticity Is a Ratio of Percentages
Once the changes in quantity demanded and price have been converted to percentages,
calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:

If demand is elastic, the ratio of percentage change in quantity demanded to percentage
change in price will have an absolute value greater than 1. If demand is inelastic, the ratio
will have an absolute value between 0 and 1. If the two percentages are equal, so that a
given percentage change in price causes an equal percentage change in quantity demanded,
elasticity is equal to -1; this is unitary elasticity.
Substituting the preceding percentages, we see that a 33.3 percent decrease in price leads
to a 100 percent increase in quantity demanded; thus,

According to these calculations, the demand for steak is elastic when we look at the range
between $2 and $3.


The Midpoint Formula
Although simple, the use of the initial values of P and Q as the bases for calculating
percentage changes can be misleading. Let us return to the example of demand for steak in
Figure 5.1(a), where we have a change in quantity demanded of 5 pounds. Using the initial
value Q1 as the base, we calculated that this change represents a 100 percent increase over
the base. Now suppose that the price of steak rises to $3 again, causing the quantity
demanded to drop back to 5 pounds. How much of a percentage decrease in quantity
demanded is this? We now have Q1 = 10 and Q2 = 5. With the same formula we used
earlier, we get

Thus, an increase from 5 pounds to 10 pounds is a 100 percent increase (because the initial
value used for the base is 5), but a decrease from 10 pounds to 5 pounds is only a 50 percent
decrease (because the initial value used for the base is 10). This does not make much sense
because in both cases, we are calculating elasticity on the same interval on the demand
curve. Changing the direction of the calculation should not change the elasticity. To
describe percentage changes more accurately, a simple convention has been adopted.
Instead of using the initial values of Q and P as the bases for calculating percentages, we
use the midpoints of these variables as the bases. That is, we use the value halfway
between P1 and P2 for the base in calculating the percentage change in price and the value
halfway between Q1 and Q2 as the base for calculating percentage change in quantity
demanded.
Thus, the midpoint formula for calculating the percentage change in quantity demanded
becomes







Price Elasticity of Supply
The Price Elasticity of Supply measures the rate of response of quantity demand due to a
price change. We calculate the Price Elasticity of Supply by the formula:
PEoS = (% Change in Quantity Supplied)/(% Change in Price)
Calculating the Price Elasticity of Supply
You may be asked "Given the following data, calculate the price elasticity of supply when
the price changes from $9.00 to $10.00" Using the chart on the bottom of the page, I'll walk
you through answering this question.
First we need to find the data we need. We know that the original price is $9 and the new
price is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that
the quantity supplied (make sure to look at the supply data, not the demand data) when the
price is $9 is 150 and when the price is $10 is 110. Since we're going from $9 to $10, we
have QSupply(OLD)=150 and QSupply(NEW)=210, where "QSupply" is short for "Quantity
Supplied". So we have:
Price(OLD)=9
Price(NEW)=10
QSupply(OLD)=150
QSupply(NEW)=210
To calculate the price elasticity, we need to know what the percentage change in quantity
supply is and what the percentage change in price is. It's best to calculate these one at a
time.
Calculating the Percentage Change in Quantity Supply
The formula used to calculate the percentage change in quantity supplied is:
[QSupply(NEW) - QSupply(OLD)] / QSupply(OLD)
By filling in the values we wrote down, we get:
[210 - 150] / 150 = (60/150) = 0.4
So we note that % Change in Quantity Supplied = 0.4 (This is in decimal terms. In
percentage terms it would be 40%). Now we need to calculate the percentage change in
price.
Calculating the Percentage Change in Price
Similar to before, the formula used to calculate the percentage change in price is:
[Price(NEW) - Price(OLD)] / Price(OLD)
By filling in the values we wrote down, we get:
[10 - 9] / 9 = (1/9) = 0.1111
We have both the percentage change in quantity supplied and the percentage change in
price, so we can calculate the price elasticity of supply.
Final Step of Calculating the Price Elasticity of Supply
We go back to our formula of:
PEoS = (% Change in Quantity Supplied)/(% Change in Price)
We now fill in the two percentages in this equation using the figures we calculated.
PEoD = (0.4)/(0.1111) = 3.6
When we analyze price elasticities we're concerned with the absolute value, but here that is
not an issue since we have a positive value. We conclude that the price elasticity of supply
when the price increases from $9 to $10 is 3.6.
How Do We Interpret the Price Elasticity of Supply?
The price elasticity of supply is used to see how sensitive the supply of a good is to a price
change. The higher the price elasticity, the more sensitive producers and sellers are to price
changes. A very high price elasticity suggests that when the price of a good goes up, sellers
will supply a great deal less of the good and when the price of that good goes down, sellers
will supply a great deal more. A very low price elasticity implies just the opposite, that
changes in price have little influence on supply.
Often you'll have the follow up question "Is the good price elastic or inelastic between $9
and $10". To answer that, use the following rule of thumb:
If PEoS > 1 then Supply is Price Elastic (Supply is sensitive to price changes)
If PEoS = 1 then Supply is Unit Elastic
If PEoS < 1 then Supply is Price Inelastic (Supply is not sensitive to price changes)
Recall that we always ignore the negative sign when analyzing price elasticity, so PEoS is
always positive. In our case, we calculated the price elasticity of supply to be 3.6, so our
good is price elastic and thus supply is very sensitive to price changes.

Data
Price Quantity Demanded Quantity Supplied
$7 200 50
$8 180 90
$9 150 150
$10 110 210
$11 60 250

http://economics.about.com/cs/micfrohelp/a/supply_elast.htm
Degrees of Elasticity of Demand
We have stated demand for a product is sensitive or responsive to price change. The
variation in demand is, however, not uniform with a change in price. In case of some
products, a small change in price leads to a relatively larger change in quantity demanded.
Elastic and Inelastic Demand:
For example, a decline of 1% in price leads to 8% increase in the quantity demanded of a
commodity. In such a case, the demand is said to elastic. There are other products where
the quantity demanded is relatively unresponsive to price changes. A decline of 8% in price,
for example, gives rise to 1% increase in quantity demanded. Demand here is said to be
inelastic.
The terms elastic and inelastic demand do not indicate the degree of responsiveness and
unresponsiveness of the quantity demanded to a change in price.
The economists therefore, group various degrees of elasticity of demand into five categories.
(1) Perfectly Elastic Demand:

A demand is perfectly elastic when a small increase in the price of a good its quantity to
zero. Perfect elasticity implies that individual producers can sell all they want at a ruling
price but cannot charge a higher price. If any producer tries to charge even one penny more,
no one would buy his product.

People would prefer to buy from another producer who sells the good at the prevailing
market price of $4 per unit. A perfect elastic demand curve is illustrated in fig. 6.1.

Diagram:



It shows that the demand curve DD
/
is a horizontal line which indicates that the quantity
demanded is extremely (infinitely) response to price. Even a slight rise in price (say $4.02),
drops the quantity demanded of a good to zero. The curve DD
/
is infinitely elastic. This
elasticity of demand as such is equal to infinity.

(2) Perfectly Inelastic Demand:

When the quantity demanded of a good dose not change at all to whatever change in price,
the demand is said to be perfectly inelastic or the elasticity of demand is zero.

For example, a 30% rise or fall in price leads to no change in the quantity demanded of a
good.

Ed = 0
30%

Ed = 0



In figure 6.2 a rise in price from OA to OC or fall in price from OC to OA causes no change
(zero responsiveness) in the amount demanded.

Ed

= 0
p

Ed = 0

(3) Unitary Elasticity of Demand:

When the quantity demanded of a good changes by exactly the same percentage as price,
the demand is said to has a unitary elasticity.

For example, a 30% change in price leads to 30% change quantity demand = 30% / 30% = 1.

One or a one percent change in price causes a response of exactly a one percent change in
the quantity demand.



In this figure (6.3) DD
/
demand curve with unitary elasticity shows that as the price falls
from OA to OC, the quantity demanded increases from OB to OD. On DD
/
demand curve,
the percentage change in price brings about an exactly equal percentage in quantity at all
points a, b. The demand curve of elasticity is, therefore, a rectangular hyperbola.

Ed = %q
%p

Ed = 1

(4) Elastic Demand:

If a one percent change in price causes greater than a one percent change in quantity
demanded of a good, the demand is said to be elastic.

Alternatively, we can say that the elasticity of demand is greater than. For example, if price
of a good change by 10% and it brings a 20% change in demand, the price elasticity is
greater than one.

Ed = 20%
10%

Ed = 2



In figure (6.4) DD
/
curve is relatively elastic along its entire length. As the price falls from
OA to OC, the demand of the good extends from OB to ON i.e., the increase in quantity
demanded is more than proportionate to the fall in price.

Ed = %q
%p

Ed > 1


(5) Inelastic Demand:

When a change in price causes a less than a proportionate change in quantity demand,
demand is said to be inelastic.

The elasticity of a good is here less than I or less than unity. For example, a 30% change in
price leads to 10% change in quantity demanded of a good, then:

Ed = 10%
30%

Ed = 1
3

Ed < 1



In figure (6.5) DD
/
demand curve is relatively inelastic. As the price fall from OA to OC, the
quantity demanded of the good increases from OB to ON units. The increase in the quantity
demanded is here less than proportionate to the fall in price.

Note: It may here note that the slope of a demand curve is not a reliable indicator of
elasticity. A flat slope of a demand curve must not mean elastic demand. Similarly, a steep
slope on demand curve must not necessarily mean inelastic demand.

The reason is that the slope is expressed in terms of units of the problem. If we change the
units of problem, we can get a different slope of the demand curve. The elasticity, on the
other hand, is the percentage change in quantity demanded to the corresponding
percentage change in price.
http://www.economicsconcepts.com/degrees_of_price_elasticity_of_demand.htm

Degrees of Price Elasticity of Supply
There are five degrees of price elasticity of supply:

(1) Infinitely Elastic Supply:

When the amount supplied at the ruling price is infinite, we say the supply is infinitely
elastic. An infinitely elastic supply curve is a horizontal straight line as is shown in the
figure 7.1.

Diagram/Figure and Example:



In this diagram 7,1, when the price is OP, the producer supplies an infinite amount of goods
if the price falls slightly below OP then nothing will be supplied by him.

(2) Elastic Supply:

When the percentage change in the amount of a good supplied is greater than the
percentage change in price that generated it. the supply is then said to be elastic supply.

For example, if the price of oranges increases from $5 to $6 and the quantity supplied rises
from 150 to 600 oranges, the supply will be elastic.



In the diagram 7.2 SS
/
supply curve is elastic and the numerical value for elasticity is
greater than 1.

(3) Unitary Elasticity:

When the percentage change in the quantity supplied is exactly equal to percentage change
in price that evoked it, the supply is said to have elasticity equal to unity, the elasticity of
supply is equal to 1.



In the diagram 7.3 SS
/
supply curve drawn through the origin has unit elasticity of supply.

(4) Inelastic Supply:

When the percentage change in the quantity supplied is less than the percentage change in
the price that generated it, the supply is said to be inelastic. The inelasticity of supply is
less than 1.



In this figure 7.4 SS
/
supply curve (which is steeper than the elastic supply curve) shows
that with a significant change in price, the quantity offered for sale is not very much
affected.

(5) Perfectly Inelastic Supply:

In perfectly inelastic-supply, the quantity supplied does not change as price changes. The
elasticity of supply in other words is zero.

For example, if the price of a painting by an artist who has died, rises from $10 thousand to
$50 thousand, the supply of the painting cannot be increased. Diagram 7.5 shows the
perfectly inelastic supply.


http://www.economicsconcepts.com/categories_of_price_elasticity_of_supply.htm

Income Elasticity of Demand
Income elasticity of demand measures how responsive quantity demanded is to a change
in income. Generally it might be thought that if incomes are rising more goods and services
will be demanded, but this is not always true. Consider a poorer person in China, southern
Europe or northern Europe. They are all used to eating a large amount of the cheapest
carbohydrate available to them, rice, pasta and potatoes respectively. If their incomes rise
would they eat more? One look at Hong Kong, Rome or Antwerp shows us that as people get
richer their diet becomes more varied. In Hong Kong burger bars abound, and in Antwerp
and Rome there is no shortage of Chinese restaurants. So as incomes rise it demand for the
traditional staple foodstuffs actually falls.With elasticity of demand we became accustomed
to ignoring the minus sign. With income elasticity of demand we need to observe the
minus/positive values carefully. A positive sign indicates that as incomes rise, more of the
good is demanded and if this is so we call the good a normal good. A good with a negative
income elasticity of demand we refer to as an inferior good. The bigger the number (positive
or negative) then the more elastic the income elasticity of demand is.
Formula for income elasticity of demand (YD)

Some texts mention luxury goods. These are goods with an income elasticity of demand
greater than +1. A rise in income, of for example 10%, leads to a more proportionate
(greater than 10%) increase in quantity demanded.


Cross Elasticity of Demand
Cross elasticity of demand (XD), or in some texts (CD), measures the responsiveness of
quantity demanded of one good to a change in price of another good.

Once again if the answer is positive or negative it reveals the nature of demand. Consider
two substitutes, Coca-Cola and Pepsi-Cola. If the price of Coca-Cola were increased we
would expect the quantity demanded of it to fall and for demand for PepsiCola to increase.
Assume that Pepsi and Coke are perfect substitutes and the price of Coke increases by 10%
and that the quantity demanded of Pepsi increases by 10%. This would give an answer of
+1.
A positive answer for cross elasticity implies that the goods are substitutes for each other.
An answer of +1 implies they are perfect substitutes. An answer of less than 1 means they
are substitutes but less than perfect.
Mobile phones and mobile phone cards are related to each other differently. If the price of
mobile phones falls we would expect the demand for mobile phone calls to be greater.
For example if Mobile phones fell in price by 10% and quantity demand for calls went up by
20%, this would give us an answer for XD of -2. Goods or services that are consumed
together like this are called complements.
Thus a negative answer implies that the goods are complements. The greater the value of
XD for complements then the stronger the relationship is.
http://www.chrisrodda.com/page46/files/Elasticity.pdf

Engels Law of Consumption
Definition of 'Engel's Law '
An economic theory introduced in 1857 by Ernst Engel, a German statistician, stating that
the percentage of income allocated for food purchases decreases as income rises. As a
household's income increases, the percentage of income spent on food decreases while the
proportion spent on other goods (such as luxury goods) increases.

For example, a family that spends 25% of their income on food at an income level of $50,000
will spend $12,500 on food. If their income increases to $100,000, it is not likely that they
will spend $25,000 (25%) on food, but will spend a lesser percentage while increasing
spending in other areas.
Engel's Law similarly states that lower income households spend a greater proportion of
their available income on food than middle- or higher-income households. As food costs
increase, both for food at home (such as groceries) and food away from home (for example,
at a restaurant), the percentage spent by lower income households is expected to increase.
http://www.investopedia.com/terms/e/engels-law.asp

Factors Affecting Consumer Behavior
Consumer behavior refers to the selection, purchase and consumption of goods and services
for the satisfaction of their wants. There are different processes involved in the consumer
behavior. Initially the consumer tries to find what commodities he would like to consume,
then he selects only those commodities that promise greater utility. After selecting the
commodities, the consumer makes an estimate of the available money which he can spend.
Lastly, the consumer analyzes the prevailing prices of commodities and takes the decision
about the commodities he should consume. Meanwhile, there are various other factors
influencing the purchases of consumer such as social, cultural, personal and psychological.
The explanation of these factors is given below.
1. Cultural Factors
Consumer behavior is deeply influenced by cultural factors such as: buyer culture,
subculture, and social class.
Culture
Basically, culture is the part of every society and is the important cause of person wants
and behavior. The influence of culture on buying behavior varies from country to country
therefore marketers have to be very careful in analyzing the culture of different groups,
regions or even countries.
Subculture
Each culture contains different subcultures such as religions, nationalities, geographic
regions, racial groups etc. Marketers can use these groups by segmenting the market into
various small portions. For example marketers can design products according to the needs
of a particular geographic group.
Social Class
Every society possesses some form of social class which is important to the marketers
because the buying behavior of people in a given social class is similar. In this way
marketing activities could be tailored according to different social classes. Here we should
note that social class is not only determined by income but there are various other factors
as well such as: wealth, education, occupation etc.
2. Social Factors
Social factors also impact the buying behavior of consumers. The important social factors
are: reference groups, family, role and status.
Reference Groups
Reference groups have potential in forming a person attitude or behavior. The impact of
reference groups varies across products and brands. For example if the product is visible
such as dress, shoes, car etc then the influence of reference groups will be high. Reference
groups also include opinion leader (a person who influences other because of his special
skill, knowledge or other characteristics).
Family
Buyer behavior is strongly influenced by the member of a family. Therefore marketers are
trying to find the roles and influence of the husband, wife and children. If the buying
decision of a particular product is influenced by wife then the marketers will try to target
the women in their advertisement. Here we should note that buying roles change with
change in consumer lifestyles.
Roles and Status
Each person possesses different roles and status in the society depending upon the groups,
clubs, family, organization etc. to which he belongs. For example a woman is working in an
organization as finance manager. Now she is playing two roles, one of finance manager and
other of mother. Therefore her buying decisions will be influenced by her role and status.
3. Personal Factors
Personal factors can also affect the consumer behavior. Some of the important personal
factors that influence the buying behavior are: lifestyle, economic situation, occupation, age,
personality and self concept.
Age
Age and life-cycle have potential impact on the consumer buying behavior. It is obvious that
the consumers change the purchase of goods and services with the passage of time. Family
life-cycle consists of different stages such young singles, married couples, unmarried
couples etc which help marketers to develop appropriate products for each stage.
Occupation
The occupation of a person has significant impact on his buying behavior. For example a
marketing manager of an organization will try to purchase business suits, whereas a low
level worker in the same organization will purchase rugged work clothes.
Economic Situation
Consumer economic situation has great influence on his buying behavior. If the income and
savings of a customer is high then he will purchase more expensive products. On the other
hand, a person with low income and savings will purchase inexpensive products.
Lifestyle
Lifestyle of customers is another import factor affecting the consumer buying behavior.
Lifestyle refers to the way a person lives in a society and is expressed by the things in
his/her surroundings. It is determined by customer interests, opinions, activities etc and
shapes his whole pattern of acting and interacting in the world.
Personality
Personality changes from person to person, time to time and place to place. Therefore it can
greatly influence the buying behavior of customers. Actually, Personality is not what one
wears; rather it is the totality of behavior of a man in different circumstances. It has
different characteristics such as: dominance, aggressiveness, self-confidence etc which can
be useful to determine the consumer behavior for particular product or service.
4. Psychological Factors
There are four important psychological factors affecting the consumer buying behavior.
These are: perception, motivation, learning, beliefs and attitudes.
Motivation
The level of motivation also affects the buying behavior of customers. Every person has
different needs such as physiological needs, biological needs, social needs etc. The nature of
the needs is that, some of them are most pressing while others are least pressing. Therefore
a need becomes a motive when it is more pressing to direct the person to seek satisfaction.
Perception
Selecting, organizing and interpreting information in a way to produce a meaningful
experience of the world is called perception. There are three different perceptual processes
which are selective attention, selective distortion and selective retention. In case of
selective attention, marketers try to attract the customer attention. Whereas, in case of
selective distortion, customers try to interpret the information in a way that will support
what the customers already believe. Similarly, in case of selective retention, marketers try
to retain information that supports their beliefs.
Beliefs and Attitudes
Customer possesses specific belief and attitude towards various products. Since such beliefs
and attitudes make up brand image and affect consumer buying behavior therefore
marketers are interested in them. Marketers can change the beliefs and attitudes of
customers by launching special campaigns in this regard.

Article Source: http://EzineArticles.com/4602848

Theory of Utility

Somehow, from the millions of things that are available, each of us manages to sort out a
set of goods and services to buy.When we make our choices, we make specific judgments
about the relative worth of things that are very different. During the nineteenth century,
the weighing of values was formalized into a concept called utility. Whether one item is
preferable to another depends on how much utility, or satisfaction, it yields relative to its
alternatives. How do we decide on the relative worth of a new puppy or a stereo? a trip to
the mountains or a weekend in New York City? working or not working? As we make our
choices, we are effectively weighing the utilities we would receive from all the possible
available goods. Certain problems are implicit in the concept of utility. First, it is
impossible to measure utility. Second, it is impossible to compare the utilities of different
peoplethat is, we cannot say whether person A or person B has a higher level of utility.
Despite these problems, however, the idea of utility helps us better understand the process
of choice. We have already seen that the focus of economics is to understand the problem
of scarcity: the problem of fulfilling the unlimited wants of humankind with limited and/or
scarce resources. Because of scarcity, economies need to allocate their resources efficiently.
Underlying the laws of demand and supply is the concept of utility, which represents the
advantage or fulfilment a person receives from consuming a good or service. Utility, then,
explains how individuals and economies aim to gain optimal satisfaction in dealing with
scarcity.

Utility is an abstract concept rather than a concrete, observable quantity. The units to
which we assign an "amount" of utility, therefore, are arbitrary, representing a relative
value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains
from consuming a given amount of goods or services in an economy. The amount of a
person's total utility corresponds to the person's level of consumption. Usually, the more the
person consumes, the larger his or her total utility will be.Marginal utility is the additional
satisfaction, or amount of utility, gained from each extra unit of consumption.

Although total utility usually increases as more of a good is consumed, marginal utility
usually decreases with each additional increase in the consumption of a good. This decrease
demonstrates the law of diminishing marginal utility. Because there is a certain threshold
of satisfaction, the consumer will no longer receive the same pleasure from consumption
once that threshold is crossed. In other words, total utility will increase at a slower pace as
an individual increases the quantity consumed.

Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet
tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate
bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional
chocolate bar will be less than the pleasure you received from eating the one before -
probably because you are starting to feel full or you have had too many sweets for one day.




This table shows that total utility will increase at a much slower rate as marginal utility
diminishes with each additional bar. Notice how the first chocolate bar gives a total utility
of 70 but the next three chocolate bars together increase total utility by only 18 additional
units.

The law of diminishing marginal utility helps economists understand the law of demand
and the negative sloping demand curve. The less of something you have, the more
satisfaction you gain from each additional unit you consume; the marginal utility you gain
from that product is therefore higher, giving you a higher willingness to pay more for it.
Prices are lower at a higher quantity demanded because your additional satisfaction
diminishes as you demand more.

In order to determine what a consumer's utility and total utility are, economists turn to
consumer demand theory, which studies consumer behavior and satisfaction. Economists
assume the consumer is rational and will thus maximize his or her total utility by
purchasing a combination of different products rather than more of one particular product.
Thus, instead of spending all of your money on three chocolate bars, which has a total
utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70,
and perhaps a glass of milk, which has a utility of 50. This combination will give you a
maximized total utility of 120 but at the same cost as the three chocolate bars.
http://www.investopedia.com/university/economics/economics5.asp

Maslows Hierarchy of Needs
The hierarchy of needs is an idea associated with one man, Abraham Maslow (see article),
the most influential anthropologist ever to have worked in industry. It is a theory about the
way in which people are motivated. First presented in a paper (A Theory of Human
Motivation) published in the Psychological Review in 1943, it postulated that human needs
fall into five different categories. Needs in the lower categories have to be satisfied before
needs in the higher ones can act as motivators. Thus a violinist who is starving cannot be
motivated to play Mozart, and a shop worker without a lunch break is less productive in the
afternoon than one who has had a break.
The theory arose out of a sense that classic economics was not giving managers much help
because it failed to take into account the complexity of human motivation. Maslow divided
needs into five:
Physiological needs: hunger, thirst, sex and sleep. Food and drinks manufacturers
operate to satisfy needs in this area, as do prostitutes and tobacco growers.
Safety needs: job security, protection from harm and the avoidance of risk. At this level
an individual's thoughts turn to insurance, burglar alarms and savings deposits.
Social needs: the affection of family and friendship. These are satisfied by such things as
weddings, sophisticated restaurants and telecommunications.
Esteem needs (also called ego needs), divided into internal needs, such as self-respect and
sense of achievement, and external needs, such as status and recognition. Industries
focused on this level include the sports industry and activity holidays.
Self-actualisation, famously described by Maslow: A musician must make music, an
artist must paint, a poet must write, if he is to be ultimately happy. What a man can be, he
must be. This need we may call self-actualisation. This involves doing things such as going
to art galleries, climbing mountains and writing novels. The theatre, cinema and music
industries are all focused on this level. Self-actualisation is different from the other levels of
need in at least one important respect. It is never finished, never fully satisfied. It is, as
Shakespeare put it, as if increase of appetite grows by what it feeds on.
An individual's position in the hierarchy is constantly shifting and any single act may
satisfy needs at different levels. Thus having a drink at a bar with a friend may be
satisfying both a thirst and a need for friendship (levels one and three). Single industries
can be aimed at satisfying needs at different levels. For example, a hotel may provide food
to satisfy level one, a nearby restaurant to satisfy level three, and special weekend tours of
interesting sites to satisfy level five.
The hierarchy is not absolute. It is affected by the general environment in which the
individual lives. The extent to which social needs are met in the workplace, for instance,
varies according to culture. In Japan the corporate organisation is an important source of a
man's sense of belonging (although not of a woman's); in the West it is much less so.
Peter Drucker took issue with the hierarchy of needs. He wrote:
What Maslow did not see is that a want changes in the act of being satisfied as a want
approaches satiety, its capacity to reward, and with it its power as an incentive, diminishes
fast. But its capacity to deter, to create dissatisfaction, to act as a disincentive, rapidly
increases.
One of Maslow's early disciples was a Californian company called NLS (Non-Linear
Systems). In the early 1960s it dismantled its assembly line and replaced it with production
teams of six or seven workers in order to increase their motivation. Each team was
responsible for the entire production process, and they worked in areas that they decorated
according to their own taste. A host of other innovations (such as dispensing with time
cards) revolutionised the company. Profits and productivity soared, but Maslow remained
sceptical. He worried that his ideas were being too easily taken as gospel truth, without
any real examination of their reliability.
http://www.economist.com/node/12407919
Law of Diminishing Marginal Utility and the Shape of its Curve
When one of the factors of production is held fixed in supply, successive additions of the
other factors will lead to an increase in returns up to a point, but beyond this point returns
will diminish. This famous law was first written about by a Frenchman, Anne Robert
Jacques Turgot and then alluded to by Thomas Malthus in his Essay on the Principle of
Population (1798). The law was discussed in England during debates on free trade and the
Corn Laws. Sometimes textbooks call it the law of decreasing (marginal) returns or the law
of variable proportions.
First we assume that there is a fixed amount of land, for example 100 acres. There is also
fixed amount of capital; a combine harvester, tractor and a barn. The amount of
entrepreneurship available is the same too. The variable factor in this model is labour and
we also assume that each person is homogenous; that is each unit of labour has identical
abilities and physical characteristics to start with. Remember that the definition of the
short run in economics is, when at least one factor of production is fixed in supply, so this is
a short-run model that we are building. Imagine the farm grows wheat. There are a number
of jobs that need doing at harvest time and these must be done quickly before weather ruins
the crop. First the wheat must be cut and gathered, the wheat and chaff must then be
separated. The wheat has then to be carted to the barn, weighed, dried out in some
instances, and then stored. All the farm machinery needs maintained, the paperwork
completed and last but not least breakfast, lunch and dinner prepared. One man working
alone will have difficulty doing all these tasks. With each person specializing there will be
gains in productivity as we saw when we looked at the division of labour earlier in the
course.
When a second worker is employed the tasks are shared. They each become more skilled in
the tasks that they specialize in and save time previously wasted by switching between
tasks. However both have to stop when a piece of machinery breaks down or one of them
stops for lunch. Employing yet another person may once again improve their productivity.
The harvest may continue as workers take their lunch in rotation for example. But
employing a fourth worker might mean productivity begins to fall (diminish).
The gains made by employing the fourth are not as great as employing the third worker.
Eventually adding more employees might even lead to an overall decrease in production as
they become bored with nothing to do and begin to interfere with production. The table
below shows what happens as each extra worker is employed. We are mainly interested in
the increase in output gained from each additional unit of labour, or the marginal physical
product. Marginal means the next unit, so the marginal physical product (MPP) is the
amount by which production rises when one extra worker is employed. MPP is calculated by
measuring the change in total physical production per worker. The average physical
product (APP) is simply the total physical product (TPP) divided by the number of workers
N.B. The Greek letter delta () is used to mean change.

Note that when we graph APP and MPP that MPP cuts the APP curve at APPs highest
point and when the third worker is employed. This is the point at which DIMINISHING
MARGINAL returns sets in. On the TPP curve, diminishing marginal returns occurs at the
point of inflection, where TPP stops accelerating.
NOTE: The marginal physical product curve is plotted at the mid points. That is MPP = 100
is plotted against 0.5 units of labour, MPP is 200 when units of labour is 1.5


Why does MPP cut the APP curve at the highest point of APP?
It is important to remember why MPP cuts APP at APPs highest point and that when you
sketch these curves you show this accurately. Many students find this hard to understand
but it is really just a simple mathematical point. Economics teachers are fond of using
cricket scores to help explain this.
Suppose a batsman comes to the wicket and scores 10 runs. The marginal score (how many
runs are added to the total is 10 and the average score is 10 (10 divided by 1)

If a second batsman scores 30 runs, the marginal is 30 (how many runs he adds) but the
average is now 40 divided by 2 which equals 20. Notice the average score went up. This is
because the marginal score is greater than the previous average. 30 is greater than 10, so
the average went up.

If a third batsman scores 20 runs, the total goes up to 60. But 20 is equal to the previous
average so the average will stay the same.

If a fourth batsman scores only 10 runs then the total rises to 70 but the average must now
fall.

So if the marginal score is greater than the previous average then the new average will
increase. If the marginal score is lower than the previous average the average will fall.
Uses of the law of diminishing marginal returns
The law of diminishing marginal returns explains why the shape of cost curves are U
shaped in the short run. The law also helps us to understand that rising populations can
often result in less income per capita unless there is also an increase in the quantities or
quality of capital too.

Indifference Curve

Suppose we measure an individual's consumption of commodity X and commodity Y along
the horizontal and vertical axes respectively and then arbitrarily pick a point in the
resulting (X , Y) space such as, for example, point A. Now imagine that we label with a plus
sign every point in the space that is preferred to point A and then label with a minus sign
every point in the space that point A is preferred to. If we then draw a line that separates
the plus from the minus signs, we will obtain the indifference curve shown in the above
figure.
The individual will be indifferent between all combinations of X and Y indicated by the
curve and will prefer all combinations above the indifference curve to any combination on
the curve. And any combination along the indifference curve will be preferred to all
combinations below it.
Since every (X , Y) combination will have an indifference curve passing through it, we can
add a third axis stretching upward from the bottom left corner of the figure measuring the
degree to which the individual's preferences are satisfied, and visualize the infinitely many
indifference curves as representing a smooth surface that rises as the consumption of
commodities X and Y increase. We denote the degree to which preferences are satisfied as
the level of utility and assume that individuals choose the combination of goods X and Y,
among those available, that maximizes their utility, with an increase in utility occurring
whenever there is an increase in the quantity of either X or Y consumed, holding
consumption of the other good constant.
Utility theory thus assumes that individuals have an internally consistent set of
preferences that do not change during the time-interval during which we are analyzing
their behaviour. In this sense we assume that individuals are rational. Irrational behaviour
is illustrated in Figure 2 below.

Suppose that an individual has indifference curves that cross, as in the case of Curve #1
and Curve #2 above. This implies that the individual is indifferent between combinations A
and B and between combinations A and C. As a result, he must be also indifferent between
points B and C. But point B has to be preferred to point C because it is above the
indifference curve on which point C is located. The individual is consuming more of both
goods at point B than at point C. The crossing of two indifference curves presents a logical
contradiction in the sense that the individual is behaving inconsistently or, as we would
say, irrationally.
Economists have often been criticized for their assumption that people are rational. After
all, we can think of many examples of people doing stupid things. Irrational behaviour of
friends and relatives and other people we observe is part of the human condition. In this
respect, however, it is important to understand that economists' definition of rationality
means simply that individuals behave consistently, however stupid and irrational that
consistent behaviour might appear to others. And while it is clear that some peoples'
behaviour may be unstable through time, the economist has to assume that the bulk of
people whose behaviour is being analyzed have unchanged preferences during the period
over which the analysis is taking place.
In fact, without an assumption that people have consistent preferences that do not change
during the period being analyzed, no coherent analysis of social behaviour would be
possible---all that would be possible is a factual delineation of what has happened in the
past by historians who must carefully avoid any interpretation of those observed facts. Of
course, psychologists and sociologists, and occasionally economists, will attempt to
determine how and why preferences change through time, but they too have to assume
coherent and internally consistent preferences that are capable of systematic
interpretation.
In the simple case portrayed in the two Figures above, economists assume that an
individual's utility can be expressed as a function of---that is, dependent on---the quantities
of commodities X and Y consumed. Mathematically, we can write
1. U = U(X , Y)
where U is the level of utility and the function U(X , Y) states simply that the level of
utility depends in some fashion on the levels of commodities X and Y consumed by the
individual. If we want to get fancy and analyse a situation where the individual's
preferences change, we could expand the utility function by inserting between the brackets
an additional input, call it Z, that measures the forces causing preferences to change,
yielding the function U(X , Y , Z). Analytical extensions of this sort are, of course, extremely
difficult if not impossible to successfully pursue.
The presentation of the utility function in Equation 1 is extremely general---without
additional specifications, the relationship denoted by U(X , Y) could take any form. Several
important features of the utility function are always specified. First, as we noted above,
increases in the levels of X and Y always lead to increases in U . That is, the partial
derivatives of the utility function with respect to X and Y ---the changes in U associated
with in small changes in each of X and Y holding the other constant---are
positive. Mathematically, this imposes the two conditions
2. U/X = U(X , Y)/X > 0 and U/Y = U(X , Y)/Y > 0
where U/X is the partial derivative of U(X , Y) with respect to X and U/Y is the
partial derivative with respect to Y. We refer to U/X and U/Y as, respectively, the
marginal utility of X and the marginal utility of Y. Equations 2 specify that marginal
utilities of X and Y are positive.
The second specified feature of the function U(X , Y) is the principle of diminishing
marginal utility. This says that the marginal utility of X declines as the quantity of X
increases and the marginal utility of Y declines as the quantity of Y increases. The slope of
an indifference curve is the negative of the ratio of the marginal utility of X over the
marginal utility of Y. To see this, imagine that the quantities of X and Y change by small
amounts. The change in utility specified in Equation 1 can then be expressed
mathematically as
3. dU = U(X , Y)/X dX + U(X , Y)/Y dY = U/X dX + U/Y dY
where the letter d preceding a variable denotes a small change in that variable. Since the
level of utility must be constant---that is dU = 0 ---along an indifference curve, Equation 3
can be rearranged to yield
0 = U/X dX + U/Y dY
which can be further rearranged as
4. dY/dX = U/X / U/Y
where dY/dX is the slope of the indifference curve. The principle of diminishing marginal
utility implies that U/X , the marginal utility of X, falls as the quantity of X consumed
increases and that U/Y , the marginal utility of Y, rises as the quantity of Y consumed
decreases. As can be seen from Equation 4, this implies that the indifference curve gets
flatter as the quantity of X consumed increases relative to the quantity of Y consumed. Or,
as we say, indifference curves are concave outward, or convex with respect to the
origin. The slope of the indifference curve is called the marginal rate of substitution, which
declines as the quantity of X increases relative to the quantity of Y.
Of course, the amounts of commodities X and Y that the individual will be able to consume
depends on the level of that person's income. If the entire income is spent on commodity X,
the maximum quantity that can be consumed is given by the distance between the origin
and point B on the horizontal axis of Figure 3 below. If the entire income is spent on
commodity Y, the maximum quantity that can be consumed is given by the vertical distance
between the origin and point A. If the prices of the two commodities facing the individual
are constant, the ratio of the price of commodity X to the price of commodity Y is given by
the slope of the budget linerunning from point A to point B.

The optimal quantities consumed will be that combination of X and Y that puts the
individual on the highest possible indifference curve---that is, quantities X0 and Y0 on the
above Figure. Note that the equilibrium quantities are those for which the slope of the
indifference curve equals the slope of the budget line---that is, where the marginal rate of
substitution equals the price ratio.
Now suppose that the level of the individual's income increases without any change in
prices. More of both commodities can now be consumed and the price ratio does not change,
so the budget line shifts outward with the new budget line being parallel to the original
one. The level of utility increases from U0 to U1 and the individual's consumption of the
two goods increases to X1 and Y1 . At this point we must keep in mind that the
indifference map in Figure 3 assumes that both X and Y are normal goods---that is, that
indifference curve U1 is tangent to the new higher budget line at a point to the right of
output level X0. In the case where X is an inferior good, this tangency would be to the left
of output level X0 and the quantity demanded of commodity X would decline as a result of
the increase in income.
Finally, let us suppose that the price of commodity X falls, with no change in money income.
The results are shown in Figure 4 below.

If the individual were to spend his entire income on commodity X, the amount of X
purchased would now be higher. Since the price of good Y has not changed, neither has the
maximum possible consumption of that commodity. The fall in the price of X has thus
reduced the slope of the individual's budget line by rotating it counter-clockwise around
point A on the vertical axis. The new utility maximum occurs at point c with a big increase
in the quantity of good X consumed and a slight decline in consumption of good Y.
It is important to distinguish between two components of the shift from the initial
equilibrium point to the final equilibrium at point c---the income effect and the substitution
effect. The decline in the price of X leads to a substitution of good X for good Y along the
initial indifference curve, holding real income---that is utility---constant. This substitution
effect is indicated by the movement from combination a to combination b along indifference
curve U0. The fact that real income has increased as a result of the decline in the price of
good X, holding nominal income and the price of good Y constant, results in an increase in
the quantities consumed of both goods, represented by the movement from combination b to
combination c. This income effect is represented by the movement from indifference
curve U0 to U1. As you can see from the above Figure, the quantity consumed of good X
increases as a result of both the substitution and income effects while the quantity of good
Y consumed declines as a result of the substitution effect and increases by slightly less than
that amount as a result of the income effect, leaving a slight overall decline.
It should now be clear why demand curves slope downward when the goods, as in the above
analysis, are substitutes for each other. It is obvious from Figure 4 that a fall in the price of
commodity X, holding nominal income constant, results in an increase in the demand for
that good. In that Figure, the fall in the price of good X also shifts the demand curve for
good Y slightly to the left because the substitution effect more than offsets the effect of the
decline in real income. Also, it is clear from Figure 3 that an increase in nominal income,
holding prices constant, shifts the demand curves of both goods to the right and, therefore,
that both commodities in that example are superior goods.
In the real world, each individual will spend her income on many goods in each period of
her life, and will face relative prices that may change from period to period along with the
interest rate, which measures the cost of consuming in the present as opposed to future
periods. In a world where consumption externalities are present, she may also experience
gains and losses in utility from the behaviour of others over which she has no control. This
means that more advanced analysis will involve a utility function with many more
arguments. On the basis of our two-commodity analysis above, however, it is reasonable to
expect that the marginal rate of substitution of each good for each other in the utility
function will, in equilibrium, equal the relative price of that pair of goods. The principles of
diminishing marginal utility and diminishing marginal rate of substitution can reasonably
be assumed to be widely applicable.
http://www.economics.utoronto.ca/jfloyd/modules/idfc.html

The Budget Line
Rose Bole has only $100 to spend on her two passions in life: buying books and attending
movies. If all books cost $5.00 and all movies cost $2.50 (these are simply assumptions to
make the problem easier--as is the assumption that only two items are involved in the
problem), the graph below shows the options open to Rose. The budget line is a frontier
showing what Rose can attain. The budget line limits choices; it is due to scarcity. The cost
of a book is $5.00 or two movies. Spending money on a product means that money cannot be
used to purchase another product. In the case of books versus movies, the tradeoff is a
straight line because one more book always costs two movies, regardless of how many books
Rose has already.

You should be able to see that the slope of the budget line depends only on the price of
books relative to the price of movies. If either books get cheaper or movies get more
expensive, the budget line in the graph above will get steeper. If this is not immediately
obvious, compute the possibilities open to a person with $100 to spend if books and movies
both cost $5.00 (a case of more expensive movies), and the possibilities open to a person
with $100 to spend if books and movies both cost $2.50 (a case of cheaper books). Graphing
the possibilities open to a person with only $50 to spend but with books costing $5.00 and
movies costing $2.50 gives you a line that is to the left of the line in the graph above, but
parallel to it, which means that it has the same slope. The amount of money available to
spend does not determine the slope of the budget line; only the ratio of prices does that.
A famous example of a budget constraint is the case of guns versus butter. During the
Second World War, the United States decided it needed to produce large amounts of
armaments (guns). It shifted factories that previously produced goods for civilian use
(butter) to the production of guns. This tradeoff could be represented as a move from a point
such as a to a point such as b in the graph below, except that at the start of the war there
was still a high level of unemployment left over from the recessions of 1929-33 and 1937-8
(a period better known as the Great Depression). Hence, the United States was not at the
limit of what it could produce, but rather at a point such as c, which indicates that more of
all goods could have been produced given the amount of resources and technology.

Though point d was a more desirable position than points a or b, it was unattainable given
technology and resources. The limit to what is possible to produce is called the production-
possibilities frontier. Its existence, which is a result of scarcity, indicates that there are
costs to producing all goods and services. During World War II, the cost of producing
thousands of tanks and jeeps was the virtual elimination of production of autos for civilian
use. The cost of feeding millions of troops in the field was a less attractive diet for the
civilian population.
The major idea in this section has been that all economic activity takes place within
limitations or constraints. Because of these constraints, choosing results in sacrificed
options. The options that are not taken, which sometimes can be measured in monetary
terms, are costs.
http://ingrimayne.com/econ/LogicOfChoice/BudgetLine.html

The Equimarginal Principle
At this point, you may think we have exhausted all the insights we can get from
the hamburger-shirt problem. We have not. The table below contains columns showing the
marginal utility of shirts and the marginal utility of hamburgers. These marginal utilities
are obtained from our original example, which shows the total utility of one shirt, two
shirts, etc. Marginal utility is the utility of the first shirt, the second shirt, etc. Thus, the
utility of the fourth hamburger is found by subtracting the utility of four hamburgers from
the utility of three hamburgers. Notice that the marginal utility of each good declines as
more of it is used. This is a case of diminishing returns that has the special title of "the law
of diminishing marginal utility." It is based on everyday observation and introspection.
After four beers, a fifth gives less pleasure than the fourth, a third hamburger gives less
satisfaction than the second, etc.
The Equimarginal Principle, or How to Spend Your Last Dollar
Number Marginal Utility of Shirts Marginal Utility of Hamburgers
First 11 8
Second 9 7
Third 7 6
Fourth 4 5
Fifth 1 4
Suppose that the person is not at the optimal solution of three shirts and two hamburgers.
Suppose instead that he has two shirts and three hamburgers. Can we tell from the table
that he has spent his money incorrectly?
We can. Shirts and hamburgers cost the same. Suppose that each costs $1.00 and the
person has $5.00 to spend. Then the last dollar spent on hamburgers gave the person only
six utils, whereas the last dollar spent on shirts gave him nine utils. The dollar spent on
shirts gave a much larger return, and if he could shift money from the area in which it is
giving a low return to the area in which it has a high return, he will be better off. This is
the basic idea of the equimarginal principle. Maximization occurs when the return on the
last dollar spent is the same in all areas. In terms of a formula, a person wants
(Marginal Benefit of A)/(Price of A) = (Marginal Benefit of B)/(Price of B)
The power of this idea can be shown if we change the original problem. Suppose that the
person still has $5.00 to spend, but the price of shirts doubles from $1.00 to $2.00. The old
solution of three shirts and two hamburgers will no longer be affordable but will lie to the
right of the budget line. To solve this new problem, two new columns must be added to our
table: the marginal utility of shirts per dollar and the marginal utility of hamburgers per
dollar. The table below adds them in columns MUs/(Price of Shirts) (the marginal utility of
shirts divided by the price of shirts) and MUh/Price of Hamburgers).
The Equimarginal Principle, Continued
Number
Marginal Utility of
Shirts
MUs
Price of
Shirts
Marginal Utility of
Hamburgers
MUh
Price of
Hamburgers
First 11 5 1/2 8 8
Second 9 4 1/2 7 7
Third 7 3 1/2 6 6
Fourth 4 2 5 5
Fifth 1 1/2 4 4

The equimarginal principle tells us to maximize utility by selecting the highest values in
the columns giving marginal utility per dollar until our budget is used up. A person with
only two dollars should buy two hamburgers rather than one shirt because both eight and
seven are larger than five and one half. A person with $5.00, as in our example, should buy
three hamburgers and one shirt. This decision does not quite equalize returns on the last
dollars spent on shirts and hamburgers, but it comes as close as possible. Any other
combination would give less utility and would allow for further improvement. For example,
if one bought two shirts and one hamburger, the extra satisfaction from a dollar spent on
shirts is only four and one half utils, whereas shifting money to hamburgers would allow
one to get seven utils per dollar.
http://ingrimayne.com/econ/LogicOfChoice/Equimarginal.html
Income and Substitution Effects
Income and Substitution Effect for a Price Increase.
If the price of a good increases, then there will be two effects.
1. The good is relatively more expensive than alternative goods and people can switch to other
goods.
2. The increase in price reduces disposable income and this lower income may reduce demand.
The substitution effect states that an increase in the price of a good will encourage
consumers to buy alternative goods. The substitution effect measures how much the higher
price encourages consumers to use other goods, assuming the same level of income.
The income effect looks at how the price change effects consumer income, and how much
the rise in income will lead to lower demand.
For example, if the price of meat increases, then the higher price may encourage consumers
to switch to alternative food sources, such as buying vegetables.
However, the higher price of meat, means that after buying some meat, they will have
lower income. Therefore, consumers will buy less meat because of this income effect.
If a good like a diamond increases, there will be little substitution effect because there are
no alternatives to diamonds. However, a higher price of diamonds will lower demand
because of the income effect.
Income and Substitution Effect for Wages.
For a worker, there is a choice between work and leisure.
If wages increase, then work becomes relatively more profitable than leisure. (substitution
effect)
However, with higher wages, he can maintain a decent standard of living through less
work. (income effect)
The substitution effect of higher wages means workers will give up leisure to do more hours
of work because work has now a higher rewards.
The income effect of higher wages mean workers will reduce the amount of hours they
work, because they can maintain a target level of income through less hours.


If the substitution effect is greater than income effect, people will work more (up to W2, L2).
However, we may get to a certain hourly wage, where we can afford to work less hours. In
the diagram above, after W2, the income effect dominates.
It depends on the worker in question. If you are lazy and prefer leisure, higher wages will
enable you to work less. The income effect will soon dominate. If you have a lot of debts and
spending commitments, the income effect will take a long time to occur.
Income and Substitution Effect for Interest rates and saving
Higher interest rates increase income from saving. Therefore, this gives consumers more
income to spend, and spending may rise (income effect)
Higher interest rates make saving more attractive than spending, reducing consumer
spending (substitution effect)
Related
Giffen Goods - where higher price leads to higher demand because the income effect of price
rise, outweighs substitution effect.
http://www.economicshelp.org/dictionary/i/income-substitution-effect.html

Paradox of Value
Why is it that some items that have relatively little use to society, such as diamonds, are
extremely expensive, whereas others that are vital, such as water, are inexpensive. Adam
Smith and other economists for a century after him struggled unsuccessfully to explain
this Paradox of Value. Though Smith never unraveled the paradox of value, you can do it
easily with a little help from the concept of consumers' surplus.
To see how this paradox is resolved, consider again the downward-sloping demand curve
discussed in the last section. As an item grows more abundant, its total use value to
consumers, which is the entire area under the demand curve, rises; but its price, or its
marginal value to consumers, declines. Thus, if two items in the table below are available,
the total value to consumers is $9.00 (or $5.00 for the first and $4.00 for the second), but the
price or value in exchange is only $4.00. If six are available, total use value rises to $15.00,
but exchange value (price) drops to $.50. Smith and his early followers missed this
distinction between marginal and total. Thus, diamonds are scarce and have a high
marginal value but a low total value. Another pound of diamonds has valuable uses that
are not currently being met. Water is tremendously abundant and thus has a high total
value and a low marginal value. Another gallon of water is not particularly important.
A Demand Curve
Price
Amount People Are
Willing to Buy
$5.00 1
$4.00 2
$3.00 3
$2.00 4
$1.00 5
$0.50 6
A Demand Curve
Price
Amount People Are
Willing to Buy
$5.00 1
$4.00 2
$3.00 3
$2.00 4
$1.00 5
$0.50 6
http://ingrimayne.com/econ/MaximizingBeha/ParadoxValue.html