AP_Krugman_Textbook

What you will learn

in this Module:

458 section 9 Behind the Demand Curve: Consumer Choice

• How the income and
  substitution effects explain
  the law of demand


• The definition of elasticity, a
  measure of responsiveness
  to changes in prices or
  incomes


• The importance of the price
  elasticity of demand, which
  measures the
  responsiveness of the
  quantity demanded to
  changes in price


• How to calculate the price
  elasticity of demand

Module 46

Income Effects,

Substitution Effects,

and Elasticity

Explaining the Law of Demand

In Section 2 we introduced the demand curve and the law of demand. To this point, we

have accepted that the demand curve has a negative slope. And we have drawn demand

curves that are somewhere in the middle between flat and steep (with a negative slope).

In this module, we present more detail about why demand curves slope downward and

what the slope of the demand curve tells us. We begin with the incomeandsubstitution ef-

fects,which explain why the demand curve has a negative slope.

The Substitution Effect

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 indi-

vidual 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—that is, it obeys the law of demand.

An alternative way to think about why demand curves slope downward is to focus

on opportunity costs. For simplicity, let’s suppose there are only two goods between

which to choose. When the price of one good decreases, an individual doesn’t have to

give up as many units of the other good in order to buy one more unit of the first good.

That makes it attractive to buy more of the good whose price has gone down. Con-

versely, when the price of one good increases, one must give up more units of the other

good to buy one more unit of the first good, so consuming that good becomes less at-

tractive and the consumer buys fewer. The change in the quantity demanded as the

good that has become relatively cheaper is substituted for the good that has become

relatively more expensive is known as the substitution effect.When a good absorbs

only a small share of the typical consumer’s income, as with pillow cases and swim

Thesubstitution effectof a change in the
price of a good is the change in the quantity
of that good demanded as the consumer
substitutes the good that has become
relatively cheaper for the good that has
become relatively more expensive.