A.P. Microeconomics

1. A.P. Microeconomics Substitution & Income Effect

2. Complete Budget as Group • On Back of sheet answer the following questions: • All rent prices drop $100. • Is this an increase in your income? Explain. • Would any of your decisions change? Explain. • Uncle Jed passes on and creates a trust fund for one of you increasing your income 25% per month. • How much is your income now? • What different choices would you make?

3. Income Effects on Choices in Output Markets Income Effect- As income increases or as the price of commonly purchased good decreases, a household’s real income (or overall buying power) increases. Ex. Getting a Raise Getting Laid Off National Fuel Raising Prices by 20% Verizon cutting phone bills 33%

4. Income Effect • When Income Rises, then Demand increases = more buying power. • When the price of goods that we buy often is lowered, then we have more money (an increase in a household’s real income). = more buying power.

5. Substitution Effects on Choices in Output Markets • Substitution Effect- the idea that households will buy more of the good or service that costs less than its substitutes. • What can I buy that gives me the most utility? • When rent prices drop do I change to a different apartment, substituting a bigger apartment but now the same rent as before?

6. Income vs. Substitute Effect Both the income and substitution effects imply a negative relationship between price and quantity demanded – in other words, downward-sloping demand. When the price of something falls, ceteris paribus, we are better off, and we are likely to buy more of that good and other goods (income effect). Because lower prices also means “less expensive relative to substitutes,” we are likely to buy more of the good (substitution effect). When the price of something rises, we are worse off, and we will buy less of it (income effect). Higher price also means “more expensive relative to substitutes,” and we are likely to buy less of it and more of other goods (substitution effect).

7. Consumer Surplus • I am willing to pay $75 for the Tickle Me Elmo. The store price for Elmo is $40. I found Elmo at a store, how much money did “save”? • The difference between the maximum amount a person is willing to pay for a good and its current market price.

8. Consumer Surplus • Consumer Surplus: is the amount that consumers benefit by being able to purchase a product for a price that is less than they would be willing to pay • Let’s Graph It!!

9. Consumer Paradox • Adam Smith wrote about this phenomenon in 1776. In our consumer society we too often put a high price on items that have little intrinsic value and vice versa. • Diamond/Water Paradox • The things with the greatest value in use frequently have little or no value in exchange (water has no marginal utility). • The things with the greatest value in exchange frequently have little to no value in use (diamond has a very large marginal utility)