Topic 3 – Individual and Market Demand
Outline:
I) The Effects of Changes in Price
II) The Effects of Changes in Income
III) Income and Substitution Effects
IV) Market Demand Curves
V) Elasticities of Demand
VI) Consumer Surplus
I) The Effects of Changes in Price
Q: Holding income, preferences, and the prices of other goods constant, how will a change in the price of X affect the quantity of X purchased?
Begin with the Price-Consumption Curve (PCC)…
A) Price-Consumption Curve
Price-Consumption Curve (PCC) – Holding income, preferences, and the price of Y constant, the PCC for X is the set of optimal bundles that are traced out as the price of X varies.
It is found by connecting the locus of tangencies (between indifference curves and the budget line) that results as the budget line is rotated. (see diagram)
Use this information to plot the individual’s demand curve…
B) Individual Demand Curve
Individual Demand Curve – A curve that plots the relationship between the quantity of X consumed and the price of X, holding income, preferences, and the prices of other goods constant.
To derive the demand curve for a particular consumer,
I) The Effects of Changes in Income
Q: Holding preferences and the prices of X and Y constant, how will a change in income affect the quantity of X purchased?
Begin with the Income-Consumption Curve (ICC)…
A) Income-Consumption Curve
Income-Consumption Curve (ICC) – Holding preferences and the prices of X and Y constant, the ICC for X is the set of optimal bundles that is traced out as income varies. (see diagram)
Use this information to plot the individual’s Engel curve…
B) Engel Curve
Engel Curve – A curve that plots the relationship between the quantity of X consumed and income, holding preferences and prices constant.
To derive the Engel curve for a particular consumer,
- Record the income-quantity combinations from the ICC in a table
- Plot these points in quantity-income space (see diagram)
- Upward sloping for normal goods; downward sloping for inferior goods
II) Income and Substitution Effects of a Price Change
- When a price changes, there are actually two distinct things going on.
- Consider the case of a price increase.
(i) The Income Effect: The increase in price reduces the consumer’s purchasing power (since M/Px falls).
(ii) The Substitution Effect: The increase in price gives the consumer an incentive to substitute away from the good whose price has risen.
- The substitution effect is always away from the good whose price has risen.
- The direction of the income effect depends on whether the good is normal or inferior.
- The total effect of the price change is the sum of the income and substitution effects.
Graphically, we isolate the two effects by constructing a hypothetical budget line that is:
Parallel to the “new” budget line, but tangent to the “old” indifference curve
Income effect is shown as the difference between the hypothetical budget line and the new budget line.
Note that since these budget lines are parallel to one another, they represent the effect of a change in income, holding prices (the slope of the budget line) constant.
Substitution effect is shown as a movement along the original indifference curve after the income effect has been “canceled out” by (hypothetically) giving the consumer just enough income to return them to their original indifference curve (or hypothetically taking income away in the case of a price decrease).
Example 1 – Price increase (see diagram)
Example 2 – Price decrease (see diagram)
Giffen Goods
- The overwhelming majority of goods have downward sloping demand curves.
- However, the theory does not rule out the possibility that demand curves could be upward sloping.
- Goods with upward sloping demand curves are called Giffen Goods.
- Since the substitution effect of a price increase is always negative, a good can only be Giffen if:
(1) It is an inferior good.
(2) The income effect is larger than the substitution effect.
- For this reason, Giffen goods are most likely to arise in cases where consumers spend a large fraction of their income on an inferior good (so that the income effect will necessarily be large).
Example? The potato in 19th century Ireland
Q: Is there a condition that we can impose that will guarantee a downward-sloping demand curve?