Managerial Economics

Lecture Notes
Demand Curve Derivation
• DD curve of a consumer followes from his consumption choices that we discussed
earlier.

• We can use the utility maximization model studied earlier to show how to derive an
individual demand curve.

• We limit our discussion only to two goods: food and clothing.

• See the Graph!

• What happens when price of food increases?

• What happens when the price of food decreases?

• The utility maximization model helps us to derive individual consumer’s demand

curve!

• Price Consumption Curve: It traces the utility maximizing bundles of two goods
as the price of one good changes.

• As price of food decreases, it’s quantity demanded increases (usually this would be
the case). What about the quantity demanded of cloth when PF falls?

• Answer: Its depends!

• Change in relative price and purchasing power.

• Individual Demand Curve: Curve that relates quantity demanded of a good to its
price for a single consumer.

• Two properties of individual demand curve:

1. As we move along the demand curve, the level of utility attained changes.
Lower the PF => Higher the utility; as PF falls purchasing power of consumer
rises.
2. Every point on the demand curve is also a point where the consumer is maxi-
mizing his utility.
If PF falls then price ratio falls. MRS then falls as he consumes more of food.
And the equilibrium condition is met.
This also => that MRS falls as we move down the DD curve.

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Income changes
• See the Graphs!.

• What happens if I increases to $20?

• What happens if I increases even further?

• Income Consumption Curve(ICC): traces the utility maximizing combinations

of two goods associated with each income level (for the consumer).

• ICC slopes upward! Why?

• Because consumption of both the goods will generally increase with an increase in
consumer’s income.

• Remember: Change in good’s price will cause movement along the demand curve;
but a change in income will cause shift in dd curve as a demand curve is drawn for
a particular level of income.

• We also learnt earlier that income elasticity of demand is generally positive. This
also follows directly from ICC’s positive slope.

• Income elasticity is higher, larger the rightward shift in the dd curve.

• This is true for normal goods! These are the ones that consumers purchase more
as their income increases.

∆Q
Q
eQ,I = ∆I
I

For a normal good, eQ,I > 0

Example:-

X,Y both normal goods.

Px , Py unchanged, I1 → I2 (↑ in income.)

Finer Gradations Of Normal Goods:

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(a) Necessity:

eQ,I < 1 ⇒Income falls, but fall in demand is lesser.

[Good is a declining share of total expenditure as I ↑ ]

(b) Luxury:

eQ,I > 1 ⇒ As I ↑ ,Dd increases even more.

As I ↓ ,Dd decreases by more
[Good is an increasing share of total expenditure as income increases]

• What happens if dd for a good falls when income increases? This would imply that
income elasticity of dd is negative.

• Such goods are called as Inferior Goods. Their dd falls when income rises. Lower
quality goods fall in this category. For instance, lower quality cereals such as millets
(bajra or jowar ). As income increases a person will shift to a superior substitute,
such as, wheat!
As I ↑, Dd decreases.
⇒ eQ,I < 0
X is an inferior good here. As I increases, X falls.

How will the ICC of an inferior good look like? (Backward bending! See figure 4.3
in book.)

• Engel Curve: plots the relationship between quantity demanded (or consumed) of
good and an individual’s income.

• How will such a curve look like?

• For normal good? (Upward sloping!)

• For inferior good? (Backward Bending!) (See Fig. 4.2)

Substitute and Complementary goods

• In earlier lectures, we learnt about substitute and complementary goods!

• When would two goods be independent? When change in price of one does not have
any effect on quantity demanded of another.

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• Can we study substitutes and complements through Price Consumption Curves?

• Determining the nature of relationship between the two goods, substitutes, comple-
mentary or independent, would ultimately be an empirical exercise!

How consumer’s choice changes with Price? (Detailed Discussion)

1. Ordinary Good: A good for which quantity demanded decreases when its price
increases.
eQ,P ≡ Price elasticity of demand.
∆Q
Q
eQ,P = ∆P
P

“Percentage change in quantity dd for 1% increase in price”

For ordinary good eQ,P < 0.

2. Giffen Goods: A good for which quantity demanded increases when its price in-
creases i.e., eQ,P > 0.
⇒ upward sloping demand curve .

Although, theoretically possible, giffen goods rarely/ don’t exist.

What is behind a change in price?

Think !

What happens when price changes (say decreases).

The fall in price has two effects:

• Consumers will buy more of the good whose price has fallen. This is mainly
because of change in relative prices that makes this good relatively cheaper.
This response to change in relative prices is called substitution effect.

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• Since price of one of the good falls, there is an increase in the real purchasing
power of the consumer. This is because the same amount of goods can be
bought for less money and hence the leftover money can be used to make
additional purchases. This change in dd caused by change in real purchasing
power is called the income effect.

In general, if price of X falls from PX1 to PX2 .

→ You can buy more X. [Price lowered]
→ You can buy more of X and Y. [More bundles affordable, real income increases.]

Apply this idea to decompose the total effect of a price change. Stick with this
example.

Decomposing Total Effect Of Price Change

1. Substitution Effect: Change in quantity dd resulting from the fact that price ra-
tio has changed.

• Change in consumption of good x due to a change in the price of good x, with

the level of purchasing power held constant (Slutsky substitution effect)
• Change in consumption of good x due to a change in the price of good x, with
the level of utility held constant (Hicks substitution effect).

2. Income Effect: Change in quantity dd/dd resulting from the fact that real income
has changed.

• Change in dd of Good X, due to increase in purchasing power, keeping relative

prices constant.

To show SE:- Move the new budget constraint back so that it passes through the
original bundle (or is tangent to the original IC for Hicks substitution effect). This
shows how much qty of X is now purchased assuming real income has not changed
but X is cheaper.

Real income is unchanged in the sense that you can still purchase the original bundle
(or level of satisfaction).

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Analysis
As a result of the price change, optimal bundle is now (X ∗∗ , Y ∗∗ ) instead of (X ∗ , Y ∗ ).
⇒ Change in demand for good X ⇒ (X ∗∗ − X ∗ )
⇒ Break this down (X ∗∗ − X ∗ ) = (X ∗∗ − XB ) + (XB − X ∗ )
= IE + SE

Direction of IE and SE
(i) SE:- ⇒ increase in “own” price, quantity dd ↓ and vice versa ⇒ Always
negative (w.r.t price).

(ii) IE:- Positive for normal goods i.e. qty dded of good increases if income increases.
Negative for inferior goods.

Net Effect for normal good: +ve or −ve?

Rise in price of good: SE(-) + IE(-) => total qty dded of the good will fall.

Both SE and IE are mutually reinforcing!

What happens in case of inferior goods? [IE would take the opposite direction!]

Fun read: www.freakonomics.com/2011/06/10/the-rich-vs-poor-debate-ar

e-kids-normal-or-inferior-goods/

What will happen to the demand of inferior goods in a recession? Boom?

What’s the relation between inferior goods and the income level?

What about Giffen goods?

Giffen goods are the ones where the negative income effect dominates the substitution
effect. So, here a fall in price of a good can actually reduce its dd. Income effect is large
enough to cause the dd curve to slope upwards.

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What would be the relationship between inferior and giffen goods? Is every giffen
good an inferior good?

Calculating SEs (Slutsky) and IEs (Numerical Example)

I
Consumers dd for milk:- x = 10 + 10Px

Originally I = $120 per week.

P = $3 per quart.

120
⇒ Demand for milk) ⇒ x= x = 10 + 10∗3
= 14 quarts/week.

Now, price of milk falls to $2/quart

120
⇒ xnew = 10 + 10∗2
= 16 quarts/week.

Total change in demand ⇒ +2 quarts/week.

Substitution Effect? Income Effect?

To solve this, let us first do some algebra (generic) of IEs and SEs .

Suppose initially:-
PX x + P Y y = I
′ ′
Now suppose price changes from Px to Px . Let I denote the income level necessary to
′
keep purchasing power constant. In other words, I is the income level at new prices that
would make the original bundle (x,y) just affordable.
′
Then [∆I = I − I, ∆Px = Pxnew − Px ] and ∆I = x∆Px

Using this formula:

∆I = x∆Px = 14(2 − 3) = −14

′
⇒ I − I = −14
′
⇒ I = 120 − 14 = $106

So, $106 is the level of income required to keep purchasing power constant.

What is the demand at new price and this income level?

106
xB = 10 + = 15.3
10 ∗ 2
SE = xB − x = 15.3 − 14 = 1.3
⇒ IE = 0.7

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Changes in price of another good

The change in prices of X also leads to changes in the equilibrium quantity of Y.

Two cases:

(a) Complements: X and Y are complements if the quantity dd of one falls when the
price of the other rises.

(b) Substitutes: If Px ↑, QDY ↑

Px ↓, QDY ↓ and so on...

Cross Price Elasticity:-

“ % change in quantity dd of 1 good due to 1 percent increase in price of other”
∆Y
Y
eY,PX = ∆PX
X

if eY,PX > 0 ⇒ Substitutes; if < 0 ⇒ Complements