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Intermediate Microeconomics
W3211

Lecture 6:
Introduction
The Effect of Changing Prices
Columbia University, Spring 2016

Mark Dean: mark.dean@columbia.edu

2

3 4
The Story So Far…. Today’s Aims
• We have now learned how to solve the consumer’s 1. Discuss how demand for a good is affected by a change in its
problem own price
 Giffen Goods
• Used this to identify the demand function  Income and substitution effects
• How the consumer’s choice depends on prices and income  Compensated demand and the Slutsky equation
 Varian Ch. 6, and 8 Feldman and Serrano Ch. 4
• Discussed how demand changes with income
• Introduced the concept of the income elasticity of demand

2. Discuss how demand for a good changes with the price of

other goods
 complements and substitutes
 Varian Ch. 6, Feldman and Serrano Ch. 4

6
Own-Price Changes

 We have seen how demand changes with income

 How about with prices?

Demand and Own Price
Changes  Suppose only p1 increases, from p1’ to p1’’ and then to p1’’’.
1: Introduction

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7 8
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y.
x2 x2
p1x1 + p2x2 = y p1x1 + p2x2 = y
p1 = p1’ p1 = p1’

p1= p1’’
x1 x1

9 10
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y.
x2
p1x1 + p2x2 = y
p1 = p1’

p1=
p1’’’ p1= p1’’
x1

11 p1 12
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y.
p1 = p1’ p1 = p1’

p1’

x1*(p1’) x 1*

x1*(p1’) x1*(p1’)

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p1 13 p1 14
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y.
p1 = p1’’ p1 = p1’’

p1’ p1’

x1*(p1’) x 1* x1*(p1’) x 1*

x1*(p1’) x1*(p1’)
x1*(p1’’)

p1 15 p1 16
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y.
p1 = p1’’’
p1’’ p1’’

p1’ p1’

x1*(p1’) x 1* x1*(p1’) x 1*
x1*(p1’’) x1*(p1’’)

x1*(p1’) x1*(p1’)
x1*(p1’’) x1*(p1’’)

p1 17 p1 18
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y. p1’’’
p1 = p1’’’
p1’’ p1’’

p1’ p1’

x1*(p1’) x 1* x1*(p1’’’) x1*(p1’) x 1*

x1*(p1’’) x1*(p1’’)

x1*(p1’’’) x1*(p1’) x1*(p1’’’) x1*(p1’)

x1*(p1’’) x1*(p1’’)

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p1 19 p1 20
Ordinary Ordinary
Own-Price Changes demand curve
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1 Fixed p2 and y. p1’’’ for commodity 1

p1’’ p1’’

p1’ p1’

x1*(p1’’’) x1*(p1’) x 1* x1*(p1’’’) x1*(p1’) x 1*

x1*(p1’’) x1*(p1’’)

x1*(p1’’’) x1*(p1’) x1*(p1’’’) x1*(p1’)

x1*(p1’’) x1*(p1’’)

p1 21 22
Ordinary Own-Price Changes
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1
 The curve containing all the utility-maximizing bundles traced
p1’’ out as p1 changes, with p2 and y constant, is the p1- price offer
p1 price curve.

offer p1’  The plot of the x1-coordinate of the p1- price offer curve against
curve p1 is the ordinary demand curve for commodity 1.

x1*(p1’’’) x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’’’) x1*(p1’)
x1*(p1’’)

23 24
Own-Price Changes Own-Price Changes

 What does a p1 price-offer curve look like for Cobb-Douglas  What does a p1 price-offer curve look like for Cobb-Douglas
preferences? preferences?

Take
U( x1 , x 2 )  x1a xb2 .


Then the ordinary demand functions for commodities 1 and 2

are

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25 26
Own-Price Changes Own-Price Changes
a y
x*1 (p1 , p 2 , y)   p1
Ordinary
a  b p1
and demand curve
b y for commodity 1
x*2 (p1 , p 2 , y)   . is
a  b p2 ay
x*1 
( a  b )p1

x 1*

27 28
Own-Price Changes Perfect Complements

 What does a p1 price-offer curve look like for a perfect-  What does a p1 price-offer curve look like for a perfect-
complements utility function? complements utility function?

U( x1 , x 2 )  minx1 , x 2.
Then the ordinary demand functions
for commodities 1 and 2 are

29 30
Own-Price Changes Own-Price Changes
y y
x*1 ( p1 , p2 , y)  x*2 (p1 , p 2 , y)  . x*1 ( p1 , p2 , y)  x*2 (p1 , p 2 , y)  .
p1  p2 p1  p2
With p2 and y fixed, higher p1 causes
smaller x1* and x2*.

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31 32
Own-Price Changes Own-Price Changes
y y
x*1 ( p1 , p2 , y)  x*2 (p1 , p 2 , y)  . x*1 ( p1 , p2 , y)  x*2 (p1 , p 2 , y)  .
p1  p2 p1  p2
With p2 and y fixed, higher p1 causes With p2 and y fixed, higher p1 causes
smaller x1* and x2*. smaller x1* and x2*.

y y
As p1  0, x*1  x*2  . As p1  0, x*1  x*2  .
p2 p2
As p1   , x*1  x*2  0.

33 p1 34
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y.
x2 x2
p1 = p1’
y/p2

x*2  p1’
y
p1’ p2 y x 1*
x*1 
p1’ p 2

x1 y x1
x*1 
p1’ p 2

p1 35 p1 36
Own-Price Changes Own-Price Changes
Fixed p2 and y. Fixed p2 and y. p1’’’
x2 x2
p1 = p1’’ p1 = p1’’’
y/p2 p1’’ y/p2 p1’’

p1’ p1’
x*2 
x*2 
y y x 1* y x 1*
x*1  x*1 
p1’’ p2 p1’’ p2 y p1’’’ p2
p1’’’ p 2
y x1 y x1
x*1  x*1 
p1’’ p2 p1’’’ p2

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p1 37 38
Ordinary Ordinary Goods
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1
x2 is
y  So far, all the demand curves have been downward sloping
y/p2 p1’’ x*1  .
p1  p2  Question: does the quantity demanded of a good have to
increase as a price decreases?
x*2  p1’
 Surely it does?
y
Sigh.
p1  p2 y x 1* 

p2  A good is called ordinary if the quantity demanded of it always

increases as its own price decreases.

y x1
x*1 
p1  p 2

39 40
Ordinary Goods Ordinary Goods
Fixed p2 and y. Fixed p2 and y.
x2 x2
p1 price
offer
curve

x1 x1

41 42
Ordinary Goods Giffen Goods
Fixed p2 and y. Downward-sloping
x2 p1 demand curve
 If, for some values of its own price, the quantity demanded of a
p1 price good rises as its own-price increases then the good is called


offer Giffen.
Good 1 is
curve
ordinary

x 1*

x1

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43 44
Ordinary Goods Ordinary Goods
Fixed p2 and y. Fixed p2 and y.
x2 x2 p1 price offer
curve

x1 x1

45 46
Ordinary Goods Giffen goods
Demand curve has
Fixed p2 and y.
a positively
x2 p1 price offer p1 sloped part  Ok, so some goods are weird!
 Prices increases and so does demand!!!
curve
What is going on?



 Increase in the price of the good should cause the consumer to switch
Good 1 is to the other good and consume less (substitution effect)
However, price increases make the consumer poorer (income effect)
Giffen 

 If the good is inferior, they will consume more

 If they are really inferior, then the income effect may outweigh the
substitution effect

x 1*  Sounds crazy, and realistically this is probably an extreme effect

 Could you think of some examples?

x1  Potato in XIX century Ireland
 Rice/Sorghum in some developing countries

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More about price changes
 In order to understand the effect of price changes on
demand, we can “decompose them”

 What happens when a commodity’s price decreases?

1. Substitution effect: the commodity is relatively cheaper, so

Demand and Own Price consumers substitute it for now relatively more expensive other
commodities.
Changes
2: Income and Substitution Effects 2. Income effect: the consumer’s budget of $y can purchase
more than before, as if the consumer’s income rose, with
consequent income effects on quantities demanded.

 We will now analyze these two effects separately

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49 50
Effects of a Price Change Effects of a Price Change
Consumer’s budget is $y Consumer’s budget is $y
x2 x2
Lower price for commodity 1
y Original choice y pivots the constraint outwards
p2 p2

x1 x1

51 52
Effects of a Price Change Effects of a Price Change
Consumer’s budget is $y
x2
Lower price for commodity 1  Changes to quantities demanded due to this ‘extra’ income
y pivots the constraint outwards are the income effect of the price change

p2 Now only $y’<y are needed to buy the  It’s as if the agent became “wealthier”
original bundle at the new prices,
y'  That’s because she can buy more with same money
as if the consumer’s income has
p2 increased by $y - $y‘

x1

53 54
Pure Substitution Effect Pure Substitution Effect Only
x2

 We will now calculate these two effects separately

 How?
x 2’
 We ‘break up’ the movement of the budget line in 2

 First, we move the budget line with the new slope but so that
the original bundle was just affordable

 This is gives us a new budget set

 We compute the bundle that would be chosen by the decision

maker for this set x 1’ x1

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55 56
Pure Substitution Effect Only Pure Substitution Effect Only
x2 x2
We break up the movement of
the budget set in two steps

x 2’ x 2’

x 1’ x1 x 1’ x1
Budget Set with new prices but where
Previous bundle is just affordable

57 58
Pure Substitution Effect Only Pure Substitution Effect Only
x2 x2
Optimal choice in this new budget set

x 2’ x 2’

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1
Budget Set with new prices but where
Previous bundle is just affordable

59
Pure Substitution Effect Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1
x 2’
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Pure Substitution Effect Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’)  (x1’’,x2’’) is the
x 2’ pure substitution effect.

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1

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61 62
And Now The Income Effect And Now The Income Effect
x2 x2 The income effect is
(x1’’,x2’’)  (x1’’’,x2’’’).

x 2’ (x1’’’,x2’’’) x 2’ (x1’’’,x2’’’)

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1

It is just like a change in income!

63 So: 64
The Overall Change in Demand
x2 The change to demand due to  We can separate the change due to a price change into:
lower p1 is the sum of the
income and substitution effects,  Substitution effect: computed as the change to the optimal choice
(x1’,x2’)  (x1’’’,x2’’’). in a budget set with new prices but in which old bundle is just
affordable
x 2’ (x1’’’,x2’’’)
 Income effect: the change from that optimal choice to the new one
x2’’ – just like a change in income

 Total effect is just the sum of the two effects

x 1’ x1’’ x1

What are the signs of these effects? 65 66

Pure Substitution Effect Only
 Are these effects always positive, negative ? x2 Can the substitution effect
 First, how about the substitution effect? mean that the optimal
bundle moves to x’’?
 It must be always positive: lower price lead to more demand in the
substitution effect x2’’
 Why? See graph
x 2’

x1’’x1’ x1

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67 What are the signs of these effects? 68

Pure Substitution Effect Only
x2  Are these effects always positive?ky negative, ?
Can the substitution effect
mean that the optimal  First, how about the substitution effect?
bundle moves to x’’?
X’’’ No: otherwise x’’ weakly  It must be always positive: lower price lead to more demand in the
x2’’ better than x’ but (by substitution effect
x 2’ monotonicity)a bundle  Why? See graph
like x’’’ is strictly better
than x’’
This means x’ cannot
have been optimal in the  How about the income effect?
fist budget set

 It’s just like a change in income

 Does demand go up or down with income?
x1’’x1’ x1  If good is inferior -> negative
 If good is normal -> positive

What are the signs of these effects? 69 Example, normal good 70

 So: x2 Good 1 is normal because

 Substitution is always positive and income could be positive or higher income increases
negative (in the case of inferior goods) demand
 Total effect is always the sum
x 2’ (x1’’’,x2’’’)
 Means that: for normal goods, total effect is positive

 For inferior goods: if income effect is stronger than substitution x2’’

effect, then total effect can be negative

 This is what happens with Giffen goods

 Question: Can Giffen goods be normal?

x 1’ x1’’ x1

Effects for Normal Goods 71 Example: Inferior Goods 72

x2 Good 1 is normal because x2

higher income increases
demand, so the income
and substitution
x 2’ (x1’’’,x2’’’) effects reinforce x 2’
each other.
x2’’

x 1’ x1’’ x1 x 1’ x1

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Example: Inferior Goods 73 Example: Inferior Goods 74

x2 x2

x 2’ x 2’

x 1’ x1 x 1’ x1

Example: Inferior Goods 75 Example: Inferior Goods 76

x2 x2 The pure substitution effect is as for a normal

good. But …

x 2’ x 2’

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1

Example: Inferior Goods 77 Example: Inferior Goods 78

x2 The pure substitution effect is as for a normal x2 The pure substitution effect is as for a normal
good. But, the income effect is good. But, the income effect is
in the opposite direction. in the opposite direction. Good 1 is
income-inferior
(x1’’’,x2’’’) (x1’’’,x2’’’)
because an
x 2’ x 2’ increase to income
causes demand to
x2’’ x2’’ fall.

x 1’ x1’’ x1 x 1’ x1’’ x1

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Example: Inferior Goods 79 Effects for Giffen Goods 80

x2 x2 A decrease in p1 causes
The overall changes to demand are
the sums of the substitution and quantity demanded of
income effects good 1 to fall.
(x1’’’,x2’’’)
x 2’

x2’’
x 2’

x 1’ x1’’ x1 x 1’ x1

Effects for Giffen Goods 81 Effects for Giffen Goods 82

x2 A decrease in p1 causes x2 A decrease in p1 causes

quantity demanded of quantity demanded of
good 1 to fall. good 1 to fall.
x2’’’ x2’’’

x 2’ x 2’

x2’’
x1’’’x1’ x1 x1’’’x1’ x1’’ x1
Substitution effect
Income effect

84
The Slutsky Equation

 There is another, more elegant way of separating out the

income and substitution effects

 You will like it….

 But it means we will have to go through some new concepts a

Demand and Own Price little quickly

Changes  (Sorry)
3: The Slutsky Equation
 In my defense, these concepts which may seem a little weird
now, will seem very sensible when we start talking about firms

83

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85 86
Ordinary and Compensated Ordinary and Compensated
Demand Demand
 Here is the standard consumer problem  Here is a related problem, sometimes called the ‘dual’
problem
1. CHOOSE a consumption bundle
2. IN ORDER TO MAXIMIZE preferences 1. CHOOSE a consumption bundle

3. SUBJECT TO the budget constraint 2. IN ORDER TO MINIMIZE expenditure

 This gives rise to demand functions: amount of the good 3. SUBJECT TO utility being equal to some u*
consumed given prices and income
,

 Can also give rise to the indirect utility function: the maximum
utility that can be achieved given prices p and income y
, , , ,

87 88
The Dual Problem The Dual Problem

x 2*

u=u* u=u*

x 1*

89 90
Ordinary and Compensated Relationship between the Two
Demand Problems
 Here is a related problem, sometimes called the ‘dual’ problem  The previous picture should give you the idea that there is a
strong relationship between the two problems
1. CHOOSE a consumption bundle
 Fact:
2. IN ORDER TO MINIMIZE expenditure
,e , = ,
3. SUBJECT TO utility being equal to some u*
 In words:
 This gives rise to compensated demand functions: amount of the
good consumed given prices and utility  Figure out the amount of I would use to minimize expenditure
while achieving utility u
,
 Figure out the amount of expenditure e I need to achieve u
 Can also give rise to the expenditure function: the minimum  Figure out the amount of I would use to maximize utility if you
expenditure that can be achieved given prices p and utility u gave me e
e , , ,  These two demands are the same

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91 92
The Dual Problem Relationship between the Two
Problems
,e , = ,

 We can use this to split out income and substitution effects

, , , ,
=

 Where ,

x 2*  Rearranging
, , , ,
=
u=u*
 This already looks like an income and substitution effect

 However, we can do better

x 1*
 Makes sense: Same bundle minimizes y with respect to u and maximizes u
with respect to y

93 94
The Envelope Theorem The Envelope Theorem
,
 What about ?  Why is
,
+
,
0?
 Well, we know that e , , , , so
 First notice that, because , , ,
, , ,
= , +
0
 Claim: these last two terms are zero,
,
 Next, take the tangency condition
 This means = ,

 Follows because is the solution to an optimization problem =

 This is the ‘envelope theorem’
 You won’t get this on your first time through
 Make sure you review Implies
 Take a deep breath..

95 96
The Envelope Theorem The Envelope Theorem

 So  This tells us that

0 ,
= ,

Implies 0  And so
, , , ,
=
Implies 0
 Becomes
Implies 0
, , ,
= ,
 Assuming strict monotonicity =0
 This is the Slutsky Equation

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The Slutsky Equation

97 Hicksian Demand and 98

Increase in Price of Good 1

 This is the Slutsky Equation

, , ,
= ,

 Second term is the income effect

 First term is the ‘substitution effect’

 Impact of prices on Hicksian Demand
 i.e. while keeping utility constant
 (Slightly different from the previous substitution effect – keeping u=u*
income constant)
 Always negative

Hicksian Demand and 99 Hicksian Demand and 10

0
Increase in Price of Good 1 Increase in Price of Good 1

u=u* u=u*

10
Cross-Price Effects 2

 What happens to demand of one good as I change the price

of the other good?

 Think about it:

 If the price of cars increases does demand for petrol increase or
decrease?
If the price of cars increases, does demand for bicycles increase or
Demand and Own Price 
decrease?
Changes  The first is the case of complements: things that are generally
consumed together

 The second a case of substitutes: things that are generally

consumed instead of each other

10
1

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10 10
Cross-Price Effects 3 Cross-Price Effects 4

 Formally A perfect-complements example:

 Price increase for commodity 2 increases demand for commodity y
1 then commodity 1 is a gross substitute for commodity 2. x*1 
 Same as saying the cross-elasticity of demand is positive
, , so
p1  p 2
0
 x*1 y
Price increase for commodity 2 decreases demand for   0.
 p2 p1  p2  2

commodity 1 then commodity 1 is a gross compliment for
commodity 2.
 Same as saying the cross-elasticity of demand is negative Therefore commodity 2 is a gross
, ,
0 complement for commodity 1.
That’s why it’s called perfect complement

10 10
Cross-Price Effects 5 Cross-Price Effects 6

A Cobb- Douglas example: A Cobb- Douglas example:

by by
x*2  x*2 
so
( a  b)p 2 so
( a  b)p 2
 x*2
 0.
 p1
Therefore commodity 1 is neither a gross
complement nor a gross substitute for
commodity 2.

10
Summary 8

 Today we have done the following

1. Discuss how demand for a good is affected by a change in its
own price
 Giffen Goods
 Income and substitution effects
 Compensated demand and the Slutsky equation

Discuss how demand for a good changes with the price of

Summary
2.
other goods
 complements and substitutes

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