6.

Demand
Varian, Chapter 6

The demand curve

This curve traces out the optimal quantity of good 1, say, as its price changes Draw this curve in (x1,p1)-space
p1

p 1A p 1B p 1C

Demand curve

x 1A

x 1B

x 1C

x1

Perfect complements
Let u(x1,x2) = min{x1, x2} The demand functions are: X1(p1,p2,m) = m/(p1+p2) p1 = m/x1 - p2 X2(p1,p2,m) = m/(p1+p2) p2 = m/x2 - p1
p1

Demand

x1

Cobb-Douglas preferences
Let u(x1,x2) = aln(x1) + (1-a)ln(x2)
p1

The demand functions are:

X1(p1,p2,m) = am/p1 p1 = am/x1 X2(p1,p2,m) = (1-a)m/p2 p2 = (1-a)m/x2
Demand

x1

Quasi-linear preferences:
u(x1,x2) = f(x1) + x2
Demand for good 1 is zero if f (0) p1/p2 The optimum satisfies f (x1) = p1/p2 at an interior solution p1 = p2f (x1) Demand for good 1 is m/p1 if f (m/p1) p1/p2
p1
p2 f (0)

Demand

x1

Inverse demand
Holding m and p2 fixed, we can write the demand function as X1(p1) This function has an inverse: P1(x1) P1(x1) is the height of the demand curve for good 1

Comparative statics
Comparative statics is the study of how behavior changes as exogenous variables change

We study how the demand functions X1(p1,p2,m) and X2(p1,p2,m) change as the prices and money change

Demand as a function of money

Good 1 is normal if demand for it increases with money: X1(p1,p2,m)/m > 0 The good is inferior if demand for it falls with money: X1(p1,p2,m)/m < 0

Both goods normal

x2

xB2 xA2 A

B m increases

xA1

xB1

x1

Good 1 inferior, good 2 normal

x2

xB2

xA2

m increases

xB1 xA1

x1

Income offer curve and Engel curve

The income offer curve traces out the optimal bundles as money changes
It is drawn in (x1,x2)-space

The Engel curve traces out the quantity demanded for good i, as money changes
It is drawn in (xi,m)-space

Perfect substitutes
x2 m Engel curve slope = p1 mC mB Income offer curve m

mA

mB

mC

x1

xA1

xB1

xC1

x1

Perfect complements
m x2 Income offer curve mC mB mA Engel curve slope = p1+p2

mA

mB

mC

x1

xA1

xB1

xC1

x1

Cobb-Douglas preferences
x2 Income offer curve mC mB mA m Engel curve slope = p1/a

mA

mB

mC

x1

xA1

xB1

xC1

x1

Homothetic preferences
Perfect substitutes, perfect complements, and Cobb-Douglas preferences are examples of homothetic preferences

Demand for each good is proportional to money

Income offer curves and Engel curves are straight lines

Quasi-linear preferences
u(x1,x2) = f(x1) + x2
x2 Income offer curve mC mB mA x1 m Engel curve

mA

mB

mC

xA1

xB1 = xC1

x1

Luxuries and necessities

m Engel curve for a necessity 2m0 2m0 m0 m0 m Engel curve for a luxury

x0

x1

xi

x0

x1

xi

Demand as a function of prices

Good i (i = 1,2) is an Ordinary good if demand for it decreases as its price rises: Xi(p1,p2,m)/pi < 0 Good i is a Giffen good if demand for it increases as its price rises: Xi(p1,p2,m)/pi > 0

Good 1 is an ordinary good

x2

B A p1 decreases

xA1

xB1

x1

Good 1 is a Giffen good

x2

p1 decreases

xB1 xA1

x1

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The price offer curve

This curve traces out the optimal bundles as the price of good 1 changes Draw this curve in (x1,x2)-space
pA xAi pB xBi xCi x1 x2

Price offer curve

pC

Substitutes and complements

The demand for good 1 can be a function of the prices of the other goods

If X1(p1,p2,m)/p2 > 0, goods 1 and 2 are substitutes

If X1(p1,p2,m)/p2 < 0, goods 1 and 2 are complements If X1(p1,p2,m)/p2 = 0, goods 1 and 2 are independent

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Substitutes and complements

Perfect complements: X1(p1,p2,m) = m/(p1+p2)

X1(p1,p2,m)/p2 = -m/(p1+p2)2
Cobb-Douglas: X1(p1,p2,m) = am/p1

X1(p1,p2,m)/p2 = 0

Aggregate Demand
The aggregate demand curve is the horizontal sum of individual demand curves Consider the case of perfect complements Suppose that p2 = 5, Adam has mA = 100, Brooke has mB = 200

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Aggregate Demand
x1A = mA/(p1+p2) = 100/(p1+5) x1B = mB/(p1+p2) = 200/(p1+5) Aggregate demand is x1A + x1B = 300/(p1+5) The demand curve is p1 = (300/x1) - 5

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