Demand

PROPORTIES OF DEMAND FUNCTIONS

◆ Comparative statics analysis of

ordinary demand functions: the
study of how ordinary demands
x1*(p1,p2,M) and x2*(p1,p2,M) change
as prices p1, p2 and income M
change.
 OWN-PRICE CHANGES
◆ How does x1*(p1,p2,M) change as p1
changes, holding p2 and M constant?
◆ Suppose only p1 increases, from p1 =
1 to p1 = 2 and then to p1= 3.
 OWN-PRICE CHANGES
x2 Fixed p2 and M
p1x1 + p2x2 = M
p1 = 1

x1
 OWN-PRICE CHANGES
Fixed p2 and M
x2
p1x1 + p2x2 = M
p1 = 1

p1= 2
x1
 OWN-PRICE CHANGES
Fixed p2 and M
x2
p1x1 + p2x2 = M
p1 = 1

p1= 3
p1= 2
x1
 p1
Own-Price Changes
Fixed p2 and M
x2
p1 = 1

P1= 1

x1*(p1=1) x1*

x1*(p1=1)
x1
 p1
Own-Price Changes
Fixed p2 and M
x2
p1 = 2

P1=1

x1*(p1=1) x1*

x1*(p1=2) x1*(p1=1) x1
 p1
Own-Price Changes
Fixed p2 and M
x2
p1 = 2
P1=2
P1=1

x1*(p1=2) x1*(p1=1) x1*

x1*(p1=2) x1*(p1=1) x1
 p1
Own-Price Changes
Fixed p2 and M
x2 P1=3
p1 = 3
P1=2
P1=1

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1*

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1

 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and M for product 1
x2 P1=3

P1=2

P1=1

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1*

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1

 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and M for product 1
x2 P1=3

P1=2
P1=1
P1 price
offer x1*
x1*(p1=3) x1*(p1=2) x1*(p1=1)
curve

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1

 OWN-PRICE CHANGES
◆ The curve containing all the utility-
maximizing bundles traced out (in x1,
x2 space) as p1 changes, with p2 and
M constant, is the price offer curve.
◆ The plot of the x1co-ordinates of the
price offer curve against p1 is the
ordinary demand curve for product 1.
[Q = F(P) or X = F(P)]
 Own-Price Changes
◆ Taking quantity demanded as given
and then asking what must be price
describes the inverse demand
function of a good. [P = F(Q) or P =
F(X)]
 OWN-PRICE CHANGES
A Cobb-Douglas example:
* aM
x1 =
(a + b ) p1
is the ordinary demand function and
aM
p1 =
(a + b ) x1*
is the inverse demand function.
 OWN-PRICE CHANGES
A perfect complements example:
M
x1* =
p1 + p2

is the ordinary demand function and

M
p1 = * − p2
x1
is the inverse demand function.
 OWN-PRICE CHANGES
◆ What does a p1 price-offer curve look
like for Cobb-Douglas preferences?
◆ Take
a b
U ( x1 , x2 ) = x1 x2

Then the ordinary demand functions

for goods 1 and 2 are
 OWN-PRICE CHANGES
* aM
x1 ( p1 , p2 , M ) =
( a + b ) p1
and
* bM
x 2 ( p1 , p2 , M ) =
( a + b ) p2
Notice that x2* does not vary with p1 so the
price offer curve is flat and the ordinary
demand curve for product 1 is a
rectangular hyperbola.
Own-Price Changes
Fixed p2 and M
x2

X2*=bM/
(a+b)p2

X1*=aM/ x1
(a+b)p1
 p1
Own-Price Changes
Fixed p2 and M
x2

X2*=bM/
(a+b)p2 x1*

X1*=aM/ x1
(a+b)p1
 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and M for product 1
x2 is
X1*=aM/(a+b)p1

X2*=bM/
(a+b)p2
x1*

X1*=aM/
x1
(a+b)p1
 OWN-PRICE CHANGES
PERFECT COMPLEMENTS
◆ What does a p1 price-offer curve look
like for a perfect-complements utility
function?
U ( x1 , x 2 ) = min{ x1 , x 2 }
The ordinary demand functions
for products 1 and 2 are:
 OWN-PRICE CHANGES
PERFECT COMPLEMENTS
M
x1* ( p1 , p2 , M ) = x2* ( p1 , p2 , M ) =
p1 + p2
With p2 and M fixed, higher p1 causes
smaller x1* and x2*.
M
As *
p1 →0, x1 *
= x2 →
p2

As * *
p1 → ∞ , x1 = x2 →0
 OWN-PRICE CHANGES
PERFECT COMPLEMENTS
x2 Fixed p2 and M

x1
 OWN-PRICE CHANGES
p1
PERFECT COMPLEMENTS
Fixed p2 and M
x2
p1 = p11
M/p2
p11
M
x2* =
p11 + p2 x1*
M
x1* = 1
p1 + p2

M x1
x1* =
p11 + p2
OWN-PRICE CHANGES p1
PERFECT COMPLEMENTS

Fixed p2 and M
x2
p1 = p12
M/p2 p12

p11

M
x2* = 2 x1*
p1 + p2 M
x1* = 2
p21 + p2

x1* = 2
M x1
p1 + p2
OWN-PRICE CHANGES
p1
PERFECT COMPLEMENTS
Fixed p2 and M. p13
x2
p1 = p13
M/p2 p12

p11

M x1*
x2* = 3 M
p1 + p2 x1* = 3
p1 + p2

x1* = 3
M x1
p1 + p2
 p1
OWN-PRICE CHANGES Ordinary
PERFECT COMPLEMENTS demand curve
Fixed p2 and M p13 for product 1
x2 is
p12 * M
M/p2 x1 =
p1 + p2
p11
M
x2* =
p1 + p2
M x1*
p2

x1* =
M x1
p1 + p2
 OWN-PRICE CHANGES
PERFECT SUBSITUTES
◆ What does a price-offer curve look
like for a perfect-substitutes utility
function?
U ( x1 , x 2 ) = x1 + x 2
Then the ordinary demand functions
for products 1 and 2 are
 OWN-PRICE CHANGES
PERFECT SUBSTITUTES
 0, if p1 > p2
x ( p1 , p2 , M ) = 
*
1
 M / p1,if p1 < p2
and

0, if p1 < p2
x 2* ( p1 , p2 , M ) = 
M / p2 ,if p1 > p2
 OWN-PRICE CHANGES
PERFECT SUBSTITUTES

Homework: Draw the diagrams.

 INCOME CHANGES
◆ How does the value of x1*(p1,p2,M)
change as M changes, holding both
p1 and p2 constant?
 INCOME CHANGES
◆ A plot of quantity demanded against
income is called an Engel curve.
INCOME CHANGES
Fixed p1 and p2

M1 < M2 < M3
Engel
Income curve;
offer curve M good 1
x 23 M3
x 22 M2
x 21 M1
x1 1
x1 3 x 11 x 13 x 1*
x 12 x 12
INCOME CHANGES M Engel
Fixed p1 and p2 curve;
M3 good 2
M2
M1 < M2 < M3
M1
Income
offer curve x 2
1 x 2
3
x 2*
x 22
x 23
x 22
x 21

x 11 x 13
x 12
 INCOME CHANGES and
HOMOTHETIC PREFERENCES
◆ Demand for each good goes up by
the same proportion as income
◆ Income offer curve (also known as
the income expansion path) is a
straight line through the origin
◆ Engel curve is a straight line through
the origin
 HOMOTHETICITY
◆ A consumer’s preferences are
homothetic if and only if
(x1, x2) > (y1, y2) ⇔ (tx1, tx2) > (ty1, ty2)
for all positive t.
 HOMOTHETICITY
Linear expansion path through the
origin

X2

X1
 Income Effects
◆ A product for which quantity
demanded rises with income is
called normal.
◆ Therefore a normal product’s Engel
curve is positively sloped.
 Income Effects
◆ A product for which quantity
demanded falls as income increases
is called inferior.
◆ Therefore an inferior product’s Engel
curve is negatively sloped.
Income Changes: Products 1 & 2
M Engel
Normal curve;
M3 good 2
M2
M1
Income
offer curve M x 21 x 23 x 2*
x 22
x 23 M3
x 22 Engel
M2
x 21 curve;
M1
good 1
x 11 x 13 x 11 x 13 x 1*
x 12 x 12
 As income
changes… Engel curves
M
x2 product 2

x 2*
M Inferior ∆x1/∆M<0
product 1
Normal ∆x1/∆M>0
x1 x 1*
Product 2 Is Normal, Product 1 Becomes Inferior
 ORDINARY PRODUCTS
◆ A product is called ordinary if the
quantity demanded always increases
as its own price decreases.
 ORDINARY PRODUCTS
Fixed p2 and M. Downward sloping
x2 p1 demand curve
p1 price

⇔
offer Product 1 is
curve ordinary

x1*

x1
 GIFFEN PRODUCTS
◆ If, for some values of its own price,
the quantity demanded of a product
rises as its own price increases then
the product is called a Giffen
product.
 GIFFEN PRODUCTS
Fixed p2 and M Demand curve has
x2 p1 a positively
p1 price offer sloped part
curve

⇔
Product 1 is
Giffen

x1*

x1
 CROSS PRICE EFFECTS
◆ If an increase in p2
– increases demand for product 1 then
product 1 is a gross substitute for
product 2.
– reduces demand for product 1 then
product 1 is a gross complement for
product 2.
 CROSS PRICE EFFECTS
A perfect complements example:
M
x1* =
p1 + p2
so
∂ x1* M
=− < 0.
∂ p2 ( p1 + p2 ) 2

Therefore product 2 is a gross

complement for product 1
 CROSS PRICE EFFECTS
p1
Increase the price of
p13 product 2 from p21 to p22
and
p12

p11

x1*
 CROSS PRICE EFFECTS
p1 Increase the price of
product 2 from p21 to p22
p13 and the demand curve
for product 1 shifts inwards
p12 -- product 2 is a
complement for product 1.
p11

x1*
 CROSS PRICE EFFECTS

A Cobb- Douglas example:

* bM
x2 =
so ( a + b ) p2
 CROSS PRICE EFFECTS
A Cobb- Douglas example:
bM
x 2* =
( a + b ) p2
so
∂ *
x2
=0
∂p1
Therefore product 1 is neither a gross
complement nor a gross substitute for
product 2.
 SUMMARY I
Changes in income
*
Cobb Douglas * aM ∂ x a
x1 = ⇒ 1
= >0
p1 ∂ M p1

*
* M ∂ x11
Perfect Substitutes x1 = ⇒ = >0
p1 ∂ M p1

*
* M ∂ x 1
x1 = ⇒ 1
= >0
p1 + p2 ∂ M p1 + p2 Perfect Complements
 SUMMARY II
Cross Price Changes
*
Cobb Douglas * aM ∂ x
x1 = ⇒ 1 =0
p1 ∂ p2

*
Perfect Substitutes * M ∂ x1
x1 = ⇒ =0
(Be Careful!) p1 ∂ p2
*
* M ∂ x −M
x1 = ⇒ 1
= <0
p1 + p2 ∂ p2 ( p1 + p2 ) 2
Perfect Complements