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?