Shifts in income holding prices constant are reflected in parallel shifts in the budget constraint and affect a consumer’s demand curve. An Engel curve shows the relationship between income and the quantity of a good demanded. Whether an increase in income raises or reduces the quantity demanded of a good depends on the type of good. Normal goods are those for which demand increases with income. Inferior goods are those for which demand decreases with income. Within normal goods, goods with an income elasticity between zero and 1 (those whose share of expenditure rises more slowly than income rises) are called necessity goods. Goods with an income elasticity greater than 1 (those whose share of expenditure grows faster than income) are called luxury goods. [Section 5.1]
The way in which changes in the price of a good affect the quantity demanded of that good is what creates the shape of the demand curve. We construct a consumer’s demand curve by examining what happens to a consumer’s utility-
The total effect on the quantity demanded of a good in response to a change in its own price can be broken down into two components.
The substitution effect causes the consumer to shift toward the good that becomes relatively cheaper and away from the good that becomes relatively more expensive. This shows up as a movement along the consumer’s initial indifference curve, driven by the change in relative prices.
The income effect occurs because a change in the price of a good changes the purchasing power of the consumer; a price drop increases purchasing power and expands the set of bundles a consumer may choose from, while a rise in price decreases purchasing power and reduces the consumer’s options. The income effect shows up as a move to a new indifference curve, reflecting a change in utility for the consumer. The direction of the income effect on quantity demanded depends on whether the good is normal (where demand rises when income rises) or inferior (demand falls when income rises). If the income effect is large enough for inferior goods, it is theoretically possible for the quantity demanded of a good to rise when its price rises. However, these types of goods, called Giffen goods, are exceedingly rare in the real world. [Section 5.3]
Changes in the prices of other goods shift the demand curve for a good. Which ways these cross-
Individuals’ demand curves are aggregated to get total market demand. Market demand at a given price is the sum of all individual demands at that same price. Another way of saying this is that market demand is the horizontal (i.e., quantity) sum of individual demands. [Section 5.5]