When studying demand and supply, you learn that a price change is considered the

Question

When studying demand and supply, you learn that a price change is considered the most important determinant of the quantity demanded for a good or service. It may seem odd that in discussing the determinants of total spending or aggregate expenditure, the textbook states that the most important determinant of consumption is the current disposable income of households.

A. If changes in price are important determinants of consumption in individual markets, why aren’t they important in determining total consumption expenditures? The key to answering this question is to understand the difference between a relative price change and a change in the price level, or the average of all prices. In microeconomics, a change in the price of a good or service is a relative price change. For example, if the price of bottled water falls, it is assumed that the prices of other goods and services do not change. Because bottled water becomes less expensive compared to other items, the quantity demanded of water will increase. In macroeconomics, the focus is not on changes in prices and quantities in individual markets but changes in the economy as a whole. Therefore, when there is a change in the price level this does not refer to a change in one market but in all markets. An increase in the price level of 10 percent means there is no change in the relative price of bottled water because all other prices have increased by 10 percent as well. But if current disposable income were to increase by 10 percent, then consumers have more income to spend on all goods and services. Economists consider this type of change to be most important in determining consumption.

Changes in aggregate expenditure are related to changes in the price level. Economists use an aggregate demand (AD) curve to analyze this relationship. This curve shows the relationship between the level of planned expenditure and the price level, holding constant other factors such as interest rates and wealth that affect aggregate expenditure. The textbook shows the aggregate demand curve as a downward-sloping line, just as the demand curve for a single good or service is drawn as a downward-sloping line.

B. If the price level were to fall, the AD curve shows there will be an increase in planned aggregate expenditure or real GDP. One reason for this will be an increase in consumption. If relative prices do not fall as the price level falls, what would explain the increase in consumption?

Explanation / Answer

answer to question A.

The price of the commodity is the major detrminent of quantity demanded of that commodity.Real disposible income of the person is also determines it. Weather price or income is important is depends on the relative change that happen in both of them. If there is a increase in price and also disposible income of the person amd if the relative price change is higher than income, it implies that there is a decrease in the real disposible income of the person.

that means, if there is a hike in price of commodities, it actually decraesing the real disposible income and the purchasing power of the person. Theirfor in determining total consumption expenditure, there is no need for considering the 'price' seperatly.

answer to question B

Eventhough there is a fall in price without a fall in relative price level, AD will go up. This is because, when price of the commodity falls, the disposible income of the person increasing in net effect. Here the consumer is in surplus- beacuse he/she got the commodity at lower price than the expectation. He can purchace more quantity of the same commodity or he can substitute that net surplus income to purchase other commodities.

Here the AD going up without a fall in relative prices.

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