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EC10C Lecture Notes Unit 3 Part 3
EC10C Lecture Notes Unit 3 Part 3
In this section of the Lecture Notes we look at the : 1. Income Consumption Curve and the Engel Curve. 2. Price Consumption Curve and the Derivation of the Demand Curve from the Price Consumption Curve. 3. Decomposition of the Total Price Effect in to the Income and Substitution Effects for the cases of Normal, Inferior and Giffen goods. 4. The difference between individual demand and market demand.
IC 3 IC 2 IC 1
0
BL 1 BL 2 BL 3
Good X
Engel Curve
Engel Curve
0
Good X or Good Y
0 Good X or Good Y
Good Y
Good X
BL 1 BL 2 BL 3
0
BL 1 BL 2 BL 3
Good X
Price P1
P2 P3
Demand Curve X2 X3 Quantity Demanded
0 X1
P RI Q
P Q
P is price, Q is quantity that is consumed of the good and RI is real income (or the purchasing power of income).
Good Y
A
1
2
IC 2 IC 1
0
X*1 X X*2
Good X B C
Our initial consumer equilibrium is at 1, where the original budget line AB forms a tangent to the indifference curve IC 1. A decrease in the price of the good X will mean that more of that good can be purchased. The move from 1 to 2 is the substitution effect. The substitution effect is shown by dashed budget line AB, which holds real income (purchasing power) constant. The budget line AB keeps us on the same indifference curve IC 1. The substitution effect says that if the price of a good falls then persons will switch to consuming more that good.
Inferior Good
SE IE
SE: IE: TPE:
P Q
P RI Q
P Q
Good Y
A A
1 2 3
IC 2 IC 1
0
X*2 X
Good X B B C
The original equilibrium is at 1, where the budget line AB forms a tangent to the indifference curve IC 1. The substitution effect is from 1 to 2 and the dashed budget line AB keeps real income constant. Although it is an inferior good, the substitution effect will mean that the decrease in price will still result in an increase in quantity demanded.
Giffen Good
IE SE
SE: IE: TPE:
P Q
P RI Q
P Q
Good Y A
IC 2
1 2
IC 1 0
X*2 X*1 X
Good X B C
P RI Q
P Q
P is price, Q is quantity that is consumed of the good and RI is real income (or the purchasing power of income).
Inferior Good
SE IE
SE: IE: TPE:
P Q
P RI Q
P Q
Giffen Good
IE SE
SE: IE: TPE:
P Q
P RI Q
P Q
Individual demand refers to the amount of the good that is demanded by one person at different prices. The Market Demand refers to the total amount of the good that is demanded by all the buyers at different prices.
We can get the Market Demand by summing all the individual demands at the different prices.
Summary
For this Unit we have looked at: Factors determining Market Demand. Price Elasticity of Demand, Income Elasticity of Demand and Cross-Price Elasticity of Demand. The Theory of the Consumer Budget Constraint, Budget Line, Indifference Curve, Consumer Equilibrium. Price and Income Consumption Curves. The Decomposition of the Total Price Effect (TPE) in to the Income and Substitution Effects. The difference between individual and market demand.