8.8 Price changes

The second relevant factor influencing a household’s consumption decisions is the price of consumer goods. In this graphic, the effects of a change in the price of Good 1 can be analyzed. The effects of a price change of Good 2 are analogous. If the price of Good 1 falls, the household is able to consume more, since all previously purchasable bundles of goods in which Good 1 was consumed become cheaper. The budget line moves outwards with a pivot point on the y-axis. The slope changes to the new price ratio.
If the price for Good 1 falls, but remains constant for Good 2 more of Good 1 can be exchanged on the market for one unit of Good 2 . Thus, the relative price has fallen, the budget line is flatter. The exact combination of goods consumed by the household depends on its preferences. Normally, as in this example as well, the consumption of a good increases when the price falls. An exception to this behavior show Giffen goods.
In the case described here, the consumption of the other good, Good 2 , remains constant. This is a property of the Cobb-Douglas-utility-function used here: U = xαyβ. The proportion of the budget spent on a good (xpx = α α+βB or ypy = β α+βB) is constant. Thus, a change in the price of one good has no effect on the consumption of the other good. Therefore, the cross-price elasticity is 0. If the effect is positive, the goods are substitutive (like butter and margarine). If the effect is negative, the goods are complementary (like cars and petrol).

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de