When the price of oranges a substitute for apples falls What happens to the demand for apples?

1. Last updated
2. Save as PDF

Figure 7.3 Utility Maximization and an Individual’s Demand Curve Mary Andrews’s demand curve for apples, d, can be derived by determining the quantities of apples she will buy at each price. Those quantities are determined by the application of the marginal decision rule to utility maximization. At a price of $2 per pound, Ms. Andrews maximizes utility by purchasing 5 pounds of apples per month. When the price of apples falls to $1 per pound, the quantity of apples at which she maximizes utility increases to 12 pounds per month.

Inhaltsverzeichnis Show

• What happens to the demand when the price of a substitute falls?
• Is the price of oranges a substitute for apples increases what will happen to the demand for apples?
• How will an increase in the price of apples affect the market for oranges?
• What will happen to the demand for apples?

Figure 7.5 Deriving a Market Demand Curve The demand schedules for Mary Andrews, Ellen Smith, and Koy Keino are given in the table. Their individual demand curves are plotted in Panel (a). The market demand curve for all three is shown in Panel (b).

Figure 7.6 The Substitution and Income Effects of a Price Change This demand curve for Ms. Andrews was presented in Figure 7.5. It shows that a reduction in the price of apples from $2 to $1 per pound increases the quantity Ms. Andrews demands from 5 pounds of apples to 12. This graph shows that this change consists of a substitution effect and an income effect. The substitution effect increases the quantity demanded by 4 pounds, the income effect by 3, for a total increase in quantity demanded of 7 pounds.

Figure 7.7 Substitution and Income Effects for Inferior Goods The substitution and income effects work against each other in the case of inferior goods. The consumer begins at point A, consuming q1 units of the good at a price P1. When the price falls to P2, the consumer moves to point B, increasing quantity demanded to q2. The substitution effect increases quantity demanded to qs, but the income effect reduces it from qs to q2.

Figure 7.8: Charles Haynes – rice – CC BY-SA 2.0.

Sources: Robert Jensen and Nolan Miller, “Giffen Behavior: Theory and Evidence,” KSG Faculty Research Working Papers Series RWP02-014, 2002 available at ksghome.harvard.edu/~nmiller/giffen.html or http://ssrn.com/abstract=310863. At the authors’ request we include the following note on the preliminary version: “Because we have received numerous requests for this paper, we are making this early draft available. The results presented in this version, while strongly suggestive of Giffen behavior, are preliminary. In the near future we expect to acquire additional data that will allow us to revise our estimation technique. In particular, monthly temperature, precipitation, and other weather data will enable us to use an instrumental variables approach to address the possibility that the observed variation in prices is not exogenous. Once available, the instrumental variables results will be incorporated into future versions of the paper.” ; David McKenzie, “Are Tortillas a Giffen Good in Mexico?” Economics Bulletin 15:1 (2002): 1–7.

Price and Quantity Changes

The law of demand states that buyers

Ceteris Paribus

The law of demand assumes that no other changes take place. This assumption is called “ceteris paribus.” If we don’t make this assumption, then we may notice that the price of apples decreases while fewer apples are purchased. One explanation for this may be that the price of oranges, a substitute product, has decreased more than the price of apples, so that consumers will substitute oranges for apples. Does this violate the law of demand?

The answer is no. The law of demand assumes that no other changes take place, so we assume that the price of oranges stays the same. If we had not changed anything else (ceteris paribus), then we would have noticed an increase in the quantity purchased of apples as a result of a decrease in its price, and this conforms to the law of demand.

Substitution and Income Effects

There are two primary reasons why people purchase more of a product as its price decreases. One is the “substitution effect.” The substitution effect states that as the price of a product decreases, it becomes cheaper than competing products (assuming that prices of the other products don’t decrease). Consumers will substitute the cheaper product for the more expensive product, and vice versa. For example, if the price of apple juice decreases, then “ceteris paribus,” people will purchase more apple juice instead of, for example, orange juice.

The other effect is the “income effect.” The income effect states that as the price of a product decreases, buyers will have more income available to purchase more products, and vice versa. For example, if someone purchases 10 mobile phone applications each month at $2.00 each, this buyer’s total monthly expenditure on these apps is $20.00. If the price of the apps falls to $1.25, the total expenditure drops to $12.50. This means that this buyer now has $7.50 more income compared to when the price of the apps was $2.00. In essence, this buyer’s real income has increased. This allows the buyer to purchase more apps (law of demand).