10.4 From Utility to the Demand Curve
We have now analyzed the optimal consumption choice of a consumer with a given amount of income who faces one particular set of prices—
But the main reason for studying consumer behaviour is to go behind the market demand curve—
Marginal Utility, the Substitution Effect, and the Law of Demand
Suppose that the price of chicken wings, PW, rises. The price increase doesn’t change the marginal utility a consumer gets from an additional kilogram of wings, MUW, at any given level of wing consumption. However, it does reduce the marginal utility per dollar spent on chicken wings, MUW/PW. And the decrease in marginal utility per dollar spent on wings gives the consumer an incentive to consume fewer wings when the price of wings rises.
To see why, recall the utility-
The opposite happens if the price of wings falls. In that case the marginal utility per dollar spent on wings, MUW/PW, increases at any given level of wing consumption. As a result, a consumer can increase his or her utility by purchasing more wings and less of other goods when the price of wings falls.
So when the price of a good increases, an individual will normally consume less of that good and more of other goods. Correspondingly, when the price of a good decreases, an individual will normally consume more of that good and less of other goods. This explains why the individual demand curve, which relates an individual’s consumption of a good to the price of that good, normally slopes downward—
An alternative way to think about why demand curves slope downward is to focus on opportunity costs. When the price of wings decreases, an individual doesn’t have to give up as many units of other goods in order to buy one more unit of wings. So consuming wings becomes more attractive. Conversely, when the price of a good increases, consuming that good becomes a less attractive use of resources, and the consumer buys less.
The substitution effect of a change in the price of a good is the change in the quantity of that good consumed as the consumer substitutes other goods that are now relatively cheaper in place of the good that has become relatively more expensive.
This effect of a price change on the quantity consumed is always present. It is known as the substitution effect—the change in the quantity consumed as the consumer substitutes other goods that are now relatively cheaper in place of the good that has become relatively more expensive. When a good absorbs only a small share of an individual consumer’s spending, the substitution effect is essentially the complete explanation of why the individual demand curve of that consumer slopes downward. And, by implication, when a good absorbs only a small share of the typical consumer’s spending, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward. However, some goods, such as housing, absorb a large share of a typical consumer’s spending. For such goods, the story behind the individual demand curve and the market demand curve becomes slightly more complicated.
The Income Effect
For the vast majority of goods, the substitution effect is pretty much the entire story behind the slopes of the individual and market demand curves. There are, however, some goods, like food or housing, that account for a substantial share of many consumers’ spending. In such cases another effect, called the income effect, also comes into play.
Consider the case of a family that spends half its income on rental housing. Now suppose that the price of housing increases everywhere. This will have a substitution effect on the family’s demand: other things equal, the family will have an incentive to consume less housing—say, by moving to a smaller apartment—and more of other goods. But the family will also, in a real sense, be made poorer by that higher housing price—its income will buy less housing than before. The amount of income adjusted to reflect its true purchasing power is often termed “real income,” in contrast to “money income” or “nominal income,” which has not been adjusted. And this reduction in a consumer’s real income will have an additional effect, beyond the substitution effect, on the family’s consumption bundle, including its consumption of housing.
The change in the quantity of a good consumed that results from a change in the overall purchasing power of the consumer due to a change in the price of that good is known as the income effect of the price change. In this case, a change in the price of a good effectively changes a consumer’s income because it alters the consumer’s purchasing power. Along with the substitution effect, the income effect is another means by which changes in prices alter consumption choices.
The income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer’s purchasing power due to the change in the price of the good.
It’s possible to give more precise definitions of the substitution effect and the income effect of a price change, and we do this in Appendix 10A. For most purposes, however, there are only two things you need to know about the distinction between these two effects.
First, for the great majority of goods and services, the income effect is not important and has no significant effect on individual consumption. So most market demand curves slope downward solely because of the substitution effect—end of story.
Second, when it matters at all, the income effect usually reinforces the substitution effect. That is, when the price of a good that absorbs a substantial share of income rises, consumers of that good become a bit poorer because their purchasing power falls. As we learned in Chapter 3, the vast majority of goods are normal goods, goods for which demand decreases when income falls. So this effective reduction in income leads to a reduction in the quantity demanded and reinforces the substitution effect.
However, in the case of an inferior good, a good for which demand increases when income falls, the income and substitution effects work in opposite directions. Although the substitution effect tends to produce a decrease in the quantity of any good demanded as its price increases, in the case of an inferior good the income effect of a price increase tends to produce an increase in the quantity demanded.
As a result, there are hypothetical cases involving inferior goods in which the distinction between income and substitution effects is important. The most extreme example of this distinction is a Giffen good, a good that has an upward-sloping demand curve.
A Giffen good is a hypothetical inferior good for which the income effect outweighs the substitution effect and as a result, the demand curve slopes upward.
The classic story used to describe a Giffen good harks back to nineteenth-century Ireland, when it was a desperately poor country and a large portion of a typical household’s diet consisted of potatoes. Other things equal, an increase in the price of potatoes would have led people to reduce their demand for potatoes. But other things were not equal: for the nineteenth-century Irish, a higher price of potatoes would have left them poorer and increased their demand for potatoes because potatoes were an inferior good. If the income effect of a price increase outweighs the substitution effect—as was conjectured for potatoes in nineteenth-century Ireland—a rise in price leads to an increase in the quantity demanded. As a result, the demand curve slopes upward and the law of demand does not hold.
In theory, Giffen goods can exist; but they have never been validated in any real situation, nineteenth-century Ireland included. So as a practical matter, it’s not a subject we need to worry about when discussing the demand for most goods. Typically, income effects are important only for a very limited number of goods. Indeed, we will make the (usual) assumption that the substitution effect dominates the income effect. Therefore, the demand curve will be downward sloping even for inferior goods.
MORTGAGE RATES AND CONSUMER DEMAND
Most people buy houses with mortgages—loans backed by the value of the house. The interest rates on such mortgages change over time; for example, they fell quite a lot over the period from 2000 to 2003. And in late 2012 and early 2013, mortgage interest rates reached their lowest levels in more than 50 years. When mortgage rates fall, the cost of housing falls for millions of people—even people who have mortgages at high interest rates are often able to “refinance” them at lower rates. The percentage of Canadian families who owned their homes increased from 65.8% in 2001 to a historical high of 69% in 2011. (It seems the financial crisis of 2008-2009 and the recession that followed only slowed the rise in the homeownership rate.)
It’s not surprising that the demand for housing goes up when mortgage rates go down. Economists have noticed, however, that the demand for many other goods also rises when mortgage rates fall. Some of these goods are items connected with new or bigger houses, such as furniture. But people also buy new cars, eat more meals in restaurants, and take more vacations. Why?
The answer illustrates the distinction between substitution and income effects. When housing becomes cheaper, there is a substitution effect: people have an incentive to substitute housing in place of other goods in their consumption bundle. But housing also happens to be a good that absorbs a large part of consumer spending, with many families spending a quarter or more of their income on mortgage payments. So when the cost of housing falls, people are in effect richer—there is a significant income effect.
The increase in the quantity of housing demanded when mortgage rates fall is the result of both effects: housing becomes a better buy compared with other consumer goods, and people also buy more and bigger houses because they feel richer. And because they feel richer, they also buy more of all other normal goods, such as cars, restaurant meals, and vacations.
An unfortunate by-product of having mortgage interest rates so unusually low (and for so many years) is how many Canadians are getting themselves into financial difficulties. Low interest rates have encouraged more people to buy homes, perhaps more expensive homes than they can really afford, along with other purchases that can increase their level of consumer debt. It is not surprising to learn that, in the past decade, home prices have grown faster than incomes, and consumer debt (as a percent of after-tax income) has hit all-time highs.
Quick Review
Most goods absorb only a small fraction of a consumer’s spending. For such goods, the substitution effect of a price change is the only important effect of the price change on consumption. It causes individual demand curves and the market demand curve to slope downward.
When a good absorbs a large fraction of a consumer’s spending, the income effect of a price change is present in addition to the substitution effect.
For normal goods, demand rises when a consumer becomes richer and falls when a consumer becomes poorer, so that the income effect reinforces the substitution effect. For inferior goods, demand rises when a consumer becomes poorer and falls when a consumer becomes richer, so that the income and substitution effects move in opposite directions. But we usually assume that the substitution effect dominates the income effect.
The demand curve of a Giffen good slopes upward because it is an inferior good in which the income effect outweighs the substitution effect.
Check Your Understanding 10-4
CHECK YOUR UNDERSTANDING 10-4
Question 10.7
In each of the following cases, state whether the income effect, the substitution effect, or both are significant. In which cases do they move in the same direction? In opposite directions? Why?
Orange juice represents a small share of Clare’s spending. She buys more lemonade and less orange juice when the price of orange juice goes up. She does not change her spending on other goods.
Apartment rents have risen dramatically this year. Since rent absorbs a major part of her income, Delia moves to a smaller apartment. Assume that rental housing is a normal good.
The cost of a semester-long meal ticket at the student cafeteria rises, representing a significant increase in living costs. Assume that cafeteria meals are an inferior good.
Since spending on orange juice is a small share of Clare’s spending, the income effect from a rise in the price of orange juice is insignificant. Only the substitution effect, represented by the substitution of lemonade in place of orange juice, is significant.
Since rent is a large share of Delia’s expenditures, the increase in rent generates a significant income effect, making Delia feel poorer. Since housing is a normal good for Delia, the income and substitution effects move in the same direction, leading her to reduce her consumption of housing by moving to a smaller apartment.
Since a meal ticket is a significant share of the students’ living costs, an increase in its price will generate a significant income effect. Because cafeteria meals are an inferior good, the substitution effect (which would induce students to substitute restaurant meals in place of cafeteria meals) and the income effect (which would induce them to eat in the cafeteria more often because they are poorer) move in opposite directions.
Question 10.8
In the example described in Question 1c, how would you determine whether or not cafeteria meals are a Giffen good?
In order to determine whether any good is a Giffen good, you must first establish whether it is an inferior good. In other words, if students’ incomes decrease, other things equal, does the quantity of cafeteria meals demanded increase? Once you have established that the good is an inferior good, you must then establish that the income effect outweighs the substitution effect. That is, as the price of cafeteria meals rises, other things equal, does the quantity of cafeteria meals demanded increase? Be careful that, in fact, all other things remain equal. But if the quantity of cafeteria meals demanded truly increases in response to a price rise, you really have found a Giffen good.
Having a Happy Meal at McDonald’s
In July 2011, McDonald’s announced that it would begin making its standard child’s Happy Meal healthier. To be sure, healthier options were always available: a kid-size yogourt; juice or milk instead of a pop; a cup of apple slices instead of a small fries. But most people opted for the standard meal by default.
With healthier choices in a Happy Meal, McDonald’s is aiming to lower the salt, sugar, fat, and calorie content. But it is still up to parents to choose the beverage (low-fat milk, apple juice, or a pop), and the snack (a serving of small fries or a cup of apple slices). According to restaurant analyst Peter Saleh, “This is good publicity, and if you sell more Happy Meals, you’re selling more Big Macs to the parents.”
In the fall of 2013, McDonald’s announced that it would only list water, juice, and milk as the drink options for Happy Meals. They also promised to change advertising and packaging (so as to make healthier options more appealing to children) and to offer side salads, fruit, or vegetables as options in value meals that target teens and adults.
The changes are likely to help offset long-standing criticism of the company for the lack of nutritional balance in its menu and concerns over the growing epidemic of childhood obesity. In some U.S. cities, food advocates had proposed banning Happy Meals if they didn’t meet certain nutritional standards. Critics say that the current changes are only a small first step in the right direction.
Long-time observers say that more than just countering its critics, McDonald’s is trying to hold onto a loyal customer base: Happy Meals account for an estimated 10% of its annual sales, and a larger share of McDonald’s profits. And the competition isn’t standing still: Burger King, Pizza Pizza, Tim Hortons, White Spot, Swiss Chalet, Harvey’s, the Pickle Barrel, and others have all made menu changes to address levels of trans fats and sodium in all of their meals, including popular kids’ meals.
McDonald’s has, in fact, been amazingly successful at keeping its customers happy even in a tough environment. In 2009, at the lowest point of the recession that began in 2008, sales at full-service restaurants fell about 1% but increased by more than 3% at fast-food outlets. These restaurants kept their sales up by offering discounts and promotions as well as $1 menus and cheap combination meals.
However, many fast-food chains, such as Burger King, KFC, Boston Pizza, Taco Bell, and Pizza Pizza, saw their sales fall during the recession. Some cut back their advertising spending as the much larger McDonald’s increased its spending by 7% and increased its market share. And McDonald’s has aggressively expanded its menus—from the healthier Happy Meals to the “McCafé” line of espresso drinks, smoothies, and exotically flavoured wraps.
Observers are divided as to whether McDonald’s is earnestly attempting to get its customers to eat healthier food or is just engaging in advertising spin. One unknown is how customers will react: as one commenter said, “Salt may be bad for you, but it tastes great. … You can’t demand that McDonald’s or Burger King stop selling hamburgers and fries.” In the same vein, one franchise owner noted, “Expect customers to try the apples and then revert to asking for fries.”
QUESTIONS FOR THOUGHT
Question 10.9
Give an example of a normal good and an inferior good mentioned in this case. Cite examples of substitution effects and income effects from the case.
Question 10.10
To induce fast-food customers to eat more healthful meals, what alternatives are there to bans? Do you think these alternatives would work? Why or why not?
Question 10.11
What do you think accounts for McDonald’s success? Relate this to concepts discussed in the chapter.
