Theory of Demand

Theory of Demand
Chapter 5
Consumers in the Marketplace
Consumption choices change as a function of

price and/or income
Price increases
Lead to decreases in quantity demanded

Lead to pivoting budget line and consumers
choosing new consumption point
Contents
1.
Income Change
a.
b.
2.
Income-Consumption Curve
Normal/Inferior good
Price Change
a.
b.
c.
Price-Consumption Curve
Substitution Effect / Income Effect
Normal/Inferior/Giffen Good
Changes in Income
Composite good convention

Income changes
Result in a parallel shift of the budget line
Increase in income
Cause consumption increase if normal good

Cause consumption decrease if inferior good
Income-Consumption Curve
Assumption that prices fixed
Relationship between income and quantity
of good consumed
prices of goods consuming and indifference

curves are constant
Shape of Income-Consumption Curve
Upward-sloping if good X is normal
Downward-sloping if good X is inferior
If consumer income rises, consumes more of good X

If consumer income rises, consumes less of good X
From this, we can get an Engel Curve

showing the relationship between Income and
quantity demanded
EXHIBIT
Constructing the Engel Curve
Suppose the price of X is $2 and the price of Y is $3. Given the

following indifference curve mapping, draw an Engel curve
graph for X.
EXHIBIT
Normal and Inferior Goods
Changes in Price
Income and price of good Y remain fixed

Y-intercept of budget line unchanged by
change in price of X
Budget line pivots around y-intercept
Pivots inward if rise in price of X

Pivots outward if fall in price of X
Changes in optimum point
Located anywhere along new budget line
Suppose the price of Y is $4 and your income is $30. Suppose the price
of X falls. Given the following indifference curve mapping, generate a
demand curve for X.
Price-Consumption Curve
Locus of optimal
bundles when the
price of the good
on the x-axis
changes.
This is not a
demand curve but
the information
for a demand
curve is here
The Demand Curve
Engel curve vs demand curve
Engel curve: relationship between income and

consumption
Plots income on horizontal axis and consumption on the

vertical axis
Demand curve: relationship between price and

consumption
Plots price on the vertical axis and consumption on the

horizontal axis
Constructing the Demand Curve
Derived from indifference curves
Find price of X
Draw budget line given income and prices
Find tangency between budget line and
indifference curve
Read off quantity of X
Plot point on demand curve relating price to
quantity
Repeat the process for additional points on the
demand curve
Constructing the Demand Curve (P

falls)
From this we can get a

demand schedule and curve.
Assuming Income is constant.
Price
Qd
250
C1
200
C2
150
C3
Shape of Demand Curve
Slopes downward
If Giffen good, slopes upward
Demand and indifference curves cannot
be drawn on same graph
Require different axes
Giffen Goods
If price of X increases, quantity demanded

decreases
If price of X increases, quantity demanded

increases
Follows law of demand

Then, non-Giffen goods
Violates law of demand

Then, Giffen goods
Giffen goods rare or nonexistent
Using theory of indifference curves indicates

exception to law of demand
Non-Giffen Goods and Giffen Goods
Income and Substitution Effects

When the price of a good changes,
consumers choose a new bundle.
Economists decompose this shift from one
bundle to another into two parts: the
substitution effect and the income effect.
Substitution effect
Price rises
Adjust consumption of goods whose price above marginal
value
Income effect
Price rises
Can no longer afford previous basket
Decrease (increase) consumption if normal (inferior) good
Income and Substitution Effects
Substitution Effect: The change in Qd resulting

from a change in the relative price of a
good, and assuming the original level of
utility is maintained.
Substitution effects are always the opposite

(negative) of the price change.
Income Effect: The effect on the quantity

demanded that results from the change in
the purchasing power of a given income
when the price of a good changes.
Income effects can go either way.
Steps for solving substitution and income

effect
Solve for the initial basket

Solve for the final basket
Solve for the decomposition basket
First, the decomposition basket reflects the
price decrease, so it must lie on a budget

line that is parallel to BL .
Second, the decomposition basket reflects
the assumption that the consumer
achieves the initial level of utility after the
price decrease, so the basket must be at
the point where the budget line is tangent
to indifference curve U
2
Income and Substitution Effects:

Case 1 (x Is a Normal Good)
As the price of food drops

from Px1 to Px2, the
substitution effect leads to
an increase in the amount
of food consumed from xA
to xB (so the substitution
effect is xB xA). The
income effect also leads to
an increase in food
consumption, from xB to xC
(so the income effect is xC
xB). The overall increase
in food consumption is xC
xA. When a good is normal,
the income and substitution
effects reinforce each other.
Income and Substitution Effects: Case 2

(x Is Neither a Normal Good nor an
Inferior Good)

substitution effect leads to
an increase in the amount
of food consumed from xA to
xB (so the substitution effect
is xB xA). The income
effect on food consumption
is zero because xB is the
same as xC (so the income
effect is xC xB = 0). The
overall effect on food
consumption is xC xA.
Income and Substitution

Effects: Case 3 (x Is an Inferior Good)
with a Downward-Sloping Demand Curve

substitution effect leads
to an increase in the
amount of food consumed
from xA to xB (so the
substitution effect is xB
xA). The income effect on
food consumption is
negative (xC xB < 0).
The overall effect on food
consumption is xC xA >
0. When a good is
inferior, the income and
substitution effects work
in opposite directions.
Income and Substitution

Effects: Case 4 (x Is a Giffen Good)

substitution effect leads
to an increase in the
amount of food consumed
from xA to xB (so the
substitution effect is xB
xA). The income effect on
food consumption is
negative (xC xB < 0).
The overall effect on food
consumption is xC xA <
0.
Isolating the Substitution Effect

Suppose
given just enough money to offset

income effect (Compensated: same
indifference curve originally on)
If Px increases, the compensated budget

constraint must always be steeper than the
original budget constraint. (a negative effect on
the consumption of X)
If Px were to decrease, the compensated budget
constraint must always be flatter than the original
budget constraint. (a positive effect on the
consumption of X)
the Income Effects
If know how substitution effect changes consumption

Can deduce impact of income effect
Substitution effects are always the opposite (negative)
of the price change.
Income effects can go either way.
Price change
Income Effect
Therefore
Price increase
Negative income effect
Normal Good
Price increase
Positive income effect
Inferior Good
Price decrease
Negative income effect
Inferior Good
Price decrease
Positive income effect
Normal Good
Ordinary Inferior/ Giffen Inferior can be determined by

the relative size of Income effect to Substitution effect
Example
A consumer who purchases two goods, food and
clothing. He has the utility function U(x, y) = xy,
where x denotes the amount of food consumed
and y the amount of clothing. His marginal utilities
are MUx = y and MUy = x. Now suppose that he
has an income of $72 per week and that the price
of clothing is Py = $1 per unit. Suppose that the
price of food is initially Px1= $9 per unit, and that
the price subsequently falls to Px2= $4 per unit.
Problem: Find the numerical values of the income
and substitution effects on food consumption, and
graph the results.
Why Demand Curves Slope

Downward: Normal Goods
Geometric Observations
Increases in price, substitution effect means less

consumption
Move from compensated line to new line, income
falls, consume less of good if normal
Demand curve for normal good
Both effects move consumer leftward

Normal goods are not Giffen goods
Why Demand Curves Slope

Downward: Inferior Goods
Demand curve for inferior goods
Size of income effect
Effects move in opposite directions and not as easily

analyzed as normal good
Inferior good non-Giffen is substitution effect exceeds income
effect
Inferior good Giffen if income effect exceeds substitution
effect
Income effect of price change large if good large fraction of
consumer expenditures
Giffen goods revisited
Giffen goods are inferior

Giffen goods account for a large portion of consumer
expenditures
However, goods that make up a large portion of your budget
are generally normal.
Conditions above explain why so rare (or nonexistent)
Substitutes/Complements
When PXQY(Complements),
True/False: Y could not possibly be an inferior good for
you.
2. True/False: X could not possibly be an inferior good for
you.
1.

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Theory of Demand

Consumers in the Marketplace

Consumption choices change as a function of

Lead to decreases in quantity demanded

Composite good convention

Result in a parallel shift of the budget line

Cause consumption increase if normal good

prices of goods consuming and indifference

Shape of Income-Consumption Curve

Upward-sloping if good X is normal

Downward-sloping if good X is inferior

If consumer income rises, consumes more of good X

From this, we can get an Engel Curve

Constructing the Engel Curve

Suppose the price of X is $2 and the price of Y is $3. Given the

Normal and Inferior Goods

Income and price of good Y remain fixed

Pivots inward if rise in price of X

Changes in optimum point

Located anywhere along new budget line

The Demand Curve

Engel curve vs demand curve

Engel curve: relationship between income and

Plots income on horizontal axis and consumption on the

Demand curve: relationship between price and

Plots price on the vertical axis and consumption on the

Constructing the Demand Curve

Derived from indifference curves

Constructing the Demand Curve (P

From this we can get a

Shape of Demand Curve

Require different axes

If price of X increases, quantity demanded

If price of X increases, quantity demanded

Follows law of demand

Violates law of demand

Giffen goods rare or nonexistent

Using theory of indifference curves indicates

Non-Giffen Goods and Giffen Goods

Income and Substitution Effects

Income and Substitution Effects

Substitution Effect: The change in Qd resulting

Substitution effects are always the opposite

Income Effect: The effect on the quantity

Income effects can go either way.

Steps for solving substitution and income

Solve for the initial basket

price decrease, so it must lie on a budget

Income and Substitution Effects:

As the price of food drops

Income and Substitution Effects: Case 2

As the price of food drops

Income and Substitution

As the price of food drops

Income and Substitution

As the price of food drops

Isolating the Substitution Effect

given just enough money to offset

If Px increases, the compensated budget