1. Income and Substitution Effects
AP Economics
Mr. Bernstein
Module 46 (pp only):
Income and Substitution Effects
October 2017

2. AP Economics Mr. Bernstein
Law of Demand
All other things equal, as price increases the quantity demanded falls
So there is an inverse relationship between price and quantity demanded
Plotted on a graph, the law of demand infers a downward sloping demand curve
Why?

3. AP Economics Mr. Bernstein
The Substitution Effect
The downward sloping demand curve and opportunity costs
Costs: Driving into city = $20; bus ticket = $10
The opportunity cost of driving = 2 bus tickets
If the price of bus tickets rise to $15, the opportunity cost of driving a car decreases to 1.33 bus tickets
Driving becomes relatively cheaper and the quantity demanded rises

4. AP Economics Mr. Bernstein
The Substitution Effect
The downward sloping demand curve and opportunity costs
Costs: Driving into city = $20; bus ticket = $10
The opportunity cost of driving = 2 bus tickets
If the price of bus tickets falls to $5, the opportunity cost of driving a car increases to 4 bus tickets
Driving becomes relatively more expensive and the quantity demanded falls

5. AP Economics Mr. Bernstein
Note on the Substitution Effect
Substitution Effect causes change in Quantity Demanded for product (i.e., QD decreases as consumers shift to cheaper product
It also causes shift in Demand for substitute product (i.e., Dsub increases)

6. AP Economics Mr. Bernstein
The Income Effect
Changes in real income
Primarily effects major purchases
New job, higher income = nicer car
Lose job, lose income = less nice car
Income not keeping up with inflation = lower real income = less nice car
Reinforces Substitution Effects
Causes Demand Curve to slope downward