[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Internet Connection
WHAT WE CONSUME
The Bureau of Labor Statistics conducts regular surveys to
discover what households spend their income on. Information
from these Consumer Expenditure Surveys is available at
www.bls.gov/cex/home.htm. If you follow the link to “Consumer
Expenditures Annual Reports,” you will discover that the average
expenditure of the households surveyed in 2002 was $40,677,
of which 7.6 percent was spent on food at home, 5.1 percent on
food away from home, 32.7 percent on housing, and 1.0 percent
on public transportation. How do your expenditures compare
to those of a typical American household?
A Closer Look at the Demand
Curve
In Chapter 3, we saw the principal characteristic of the demand curve: when prices
rise, the quantity of a good demanded normally falls. Here, we take a closer look at
why. Doing so will help us understand why some goods respond more strongly to
price changes, that is, have a greater price elasticity.
Let us return to our earlier example of Fran buying CDs, shown in Figure 5.2. If
the price of CDs rises from $15 to $20, Fran will face a new budget constraint. If she
buys no CDs, she will still have $300 to spend on other goods; but if she decides to
spend all of her income on CDs, she can buy only 15 rather than 20. Figure 5.5 shows
Fran’s original budget constraint in light green and her new budget constraint in
dark green.
The increase in the price of CDs has one obvious and important effect: Fran
cannot continue to buy the same number of CDs and the same amount of other
goods as she did before. Earlier, Fran bought 11 CDs. If she again buys the same
number of CDs, it will cost her $55 more, and she will have $55 less to spend on other
goods. No matter what she does, Fran is worse off as a result of the price increase.
It is as if she had less income to spend. When she has less income to spend, she
reduces her expenditure on each good, including CDs. This part of the response to
the higher price is called the income effect. An increase in income of about $55, or
18 percent ($55 out of $300), would offset the price increase. 2 Assume the income elasticity
is approximately 1; that is, with income reduced by 18 percent, she would reduce
purchases of CDs by 18 percent, which is about 2 CDs. This part of the reduction of
the demand of CDs, from 11 to 9, is the income effect.
The magnitude of the income effect depends on two factors: how important the
commodity is to the individual—that is, how large a fraction of the individual’s income
2 Actually, it would slightly overcompensate. With the $55 increase, Fran could buy exactly the same bundle of
goods as before, but as we will soon see, she will choose to reallocate her spending. The reallocation will make
her better off.
300
OTHER GOODS ($)
Figure 5.5
CDs
15 20
EFFECT OF PRICE INCREASE
An increase in the price of CDs moves the
budget constraint down as shown. Fran
must cut back on the consumption of
some goods. Here, using the black dots
to mark her consumption points, we show
her cutting back on the consumption of
both CDs and other goods.
A CLOSER LOOK AT THE DEMAND CURVE ∂ 109