otes Week 6

23 September 2021

Demand
Demand function give the optimal amounts of each of the goods as a function of the prices and income faced by the
( Pr Pz
} right
consumer >
Xp = ✗
n , ,
m ) left hand side : the quantity demanded
> Xz = ✗ zfp, pz my
, ,
hand side : the function that relates the prices and income to that quantity
comparative statics questions in consumer theory therefore involve investigating how demand changes when prices and

income change
• Normal and inferior goods
Normal goods ,
a consumer 's demand for a
good changes as their income changes
> if good 1 is a normal
good , the demand for it increases when income increases s decreases when income decreases

✗
1
>O
m
✗2

indifference
curves

option ones
•

lines
•
budget
7

Xp

Inferior goods , an increase of income results in a reduction in the consumption of one of the goods
level that
> whether a good is inferior or not depends on the income we are examining
✗2
indifference
curves
optimal choices

• budget
lines
•

X
,

• Income offer curves and engel curves

Income offer curve illustrate the bundles of goods that are demanded at the different levels of income > also known as

income expansion path

> for normal goods ,

the income expansion path will have a positive slope

✗2

income offer
curve

Income offer curve depicts the optimal choice at different levels of

income s constant prices
indifference
curves

✗,

Engel curve is a
graph of the demand for one of the goods as a function of income with all prices being held constant

Engel
curve

Engel curve depicts the optimal choice of good 1

against income (m)

X,
 otes Week 6
23 September 2021

•o Some examples
Perfect substitutes if ,
P, < Pz the consumer is
spealizing in consuming good 1 , if their income increases they will also increase

the consumption of good 1 > the income offer curve is the horizontal axis

✗2

indifference
curves

typical line
budget
×,
income offer curve

since the demand for

good 1 is ×
,
=
Mlp , ,
the
engel curve will be a
straight line with a slope of P,
M

engel
curve

slope =P,

X
,

Perfect complements the , consumer will always consume the same amount of each good the ,
income offer curve is the diagonal line through
the origin

✗2

income offer
curve

indifference
curves

Xp

budget lines
The demand for m
/( p, P, ) line with Pz
good 1 is ×, =
+ ,
the engel curve is a
straight a slope of P, +

Mengel
curve

slope =P, + Pz

✗,

Cobb -

Douglas preferences ulxn , ,

✗ a) = ✗ it ✗ i ? the Cobb -

Douglas demand for good 1 has the form X, =

am
/p,
> linear function of m for a fixed value of Pa Where doubling m will double demand and so on
,

oea
multiplying m by any positive number t will
multiply demand by the same amount

Demand for good 2 is ✗ 2=11 -

a) m
/pz > linear function because both
, goods are linear functions of income the income
,

the
expansion path will be straight lines through origin
> the engel curve for good 1 will be a straight line with a slope of Pila
Income Offer Curve Engel Curve

✗z m

.
income offer engel curve
curve

P'
•
indifference slope =
/a
curves

✗
, Xp
budget
lines
 otes Week 6
23 September 2021

Homo thetic preferences ,

when income goes up the demand for ,
a good could increase more or less rapidly than income

increases
than income
>
luxury good , demand for a
good goes up by a
greater proportion
necessary good demand for a
good goes up a lesser proportion than income
,
by
three cases before , demand for a
good goes up by the
fame proportion as income

> if the consumer prefers (× , , ✗ a) to ly , , Yz) then they automatically prefers ltx, , txz ) to It Y, tyz)
, for any positive value of t ,

Homothetic preferences
•
perfect substitutes perfect complements
,
, s Cobb -

Douglas are all nomothetic preferences

• the income offer curves are all straight lines through the origin
> if preferences are nomothetic , it means that when income is scaled down amount t > 0 , the demanded bundle scales
up or by any up
or down by the same amount

> if the indifference curve is tangent to the budget line at 1×7 ,

✗ E) then the indifference curve through ( txt txt )
,
is tangent to

the budget line that has t times as much income S the same prices

•
engel curves are
straight lines as well

Income offer Curve

Engel Curve
✗2 M

income offer engel

curve
curve

•
indifference
•
Curves

× X,
,

budget lines

Quasi linear preferences , the case where all indifference curves are
"

shifted
"
versions of one indifference curve

> utility function : Ulx , ,

✗ a) =
V14 ) + ✗2

If an indifference curve is tangent to the budget line at a bundle ( x ,*, ✗ 2*1 , then another indifference curve is tangent to

the budget tangent at ( x ,* ,

✗ I + K ) for any constant k

> increasing income doesn't change the demand for good 1 at all > all extra income goes entirely to the consumption
of good 2

" "
•
Zero income effect for good 1

The engel curve for good 1 is a vertical line (as you change income)

Income offer curve

Engel curve
m
✗z

income
offer curve engel curve

indifference
curves

budget lines
× X
, ,

Quasi linear assumption may well be plausible , at least when the consumer 's income is sufficiently large
 otes Week 6
23 September 2021

am Ordinary goods and

Giffen goods
Ordinary goods ,
the
quantity demanded of good I should increase when its price decreases
✗2

indifference
curves

optimal when the price of good 1 decreases , the budget line becomes flatter
choices

budget
•
> the vertical intercept is fixed s the horizontal intercept moves to the
right
lines •

•
optimal choice moves to the right too > quantity demanded of
good 1 has increased

> Xp
Price decrease

Giffen goods ,
a decrease in the price of good 1 leads to a reduction in the demand for
good 1

✗2

indifference
curves
the price is to some extent like
change an income
change , even
though Mone income

remains constant in the

> a change price of a
good will
change purchasing power
9
and thereby change demand
'
lines i

! ! ✗a
<
>
reduction
in demand Price decrease
1
for good

am The price offer curve and the demand curve

of good 1 while hold P fixed

Assumption ,
let the price change we
,
S income

Price offer curve represents the bundles that would be demanded at different prices for good 1

Price offer curve

✗2

indifference
curves

Price offer curve depicts the optimal choices

Price offer
the price of 1
Changes
• •
•
curve as
good

✗
,

Demand curve
P,
50 -

Demand
curve
40 -

Demand curve depicts a plot of the optimal 30 -

choice of good 1 as a
function of its price
20
-

l l l l l ✗
y
2 4 6 8 10

The price of good increases , the demand for that good will decrease > the price s quantity of a
good will move in the opposite
demand curve will
typically
>
directions have a
negative slope
×
'
rates of change : < O

P,
 otes Week 6
23 September 2021

allow Some examples

Perfect substitutes the demand for , good 1 is zero when P, > Pz , when P, =P, the demand can be at
any
amount on the budget line

and
hyp ,
when p, < Pz > with assumption that the price of
good 2 is fix at some price p*, ( to find the demand curve )

Price Offer Curve Demand Curve

✗2
P,

indifference
curves

Demand curve
,

price offer P, =p;

1

Curve y
'

:
X
, X,
hyp ,
=
Mlp;

Perfect complements ,
whatever the prices are the consumer will demand the same amount of goods 1 and 2

line
> the price offer curve will be a
diagonal
m
the demand for good 1 : X, =
> with the assumption m and Pz are fix
p, + p,

Price offer curve Demand curve

✗2
budget
R
" n"
Price offer Demand
curve
curve

indifference
curves

'
✗y ✗,
7Pa

Discrete good if ,
P, is
very high then the consumer will strictly prefer to consume Zero units ; if P, is low
enough the consumer will

strictly prefer to consume one unit

at some price the consumer will be indifferent between consuming good 1 > reservation
> r,
,
or not
consuming it price

Optimal bundles at different prices Demand Curve

Good 2 Good 2
"

Opf¥s
•- "
,
"
r
,
:
indifferent between 1 or 0

"
& " rz : indifferent between 1 or 2
'
slope
'
-
= -
r,
-
•
• i
-
,
,
, ,
,
" r • - - - - - - -
•
'
,
" '

optimal • -

bundles
,

r • •
*
- - - - - - - - - - - - -

at rn
slope = -
r
,
,
,
iq, ,

Good 1
; ; Good 1

> as the decreases further

price , more units of the discrete good will be demanded
• r, is the price where the consumer is just indifferent between consuming 0 or 1 unit of good 1

410 m ) = UH m rn )
-
, ,

•
rz Satisfies :
UH ,
M -
ra ) = Ul 2 ,
m -
2h )
The left hand side of this equation is the utility from consuming one unit of the good at a price of rz

The right hand side is the utility from consuming two units of the
good ,
each of which sells for rz

somewhat
> if the utility function is quasi linear the reservation prices ,
become simpler
•
if Ulxi ,
✗ 2) = ✓ (Xn ) t ✗
z
and v10) = 0 > v10) + m = m = v11 ) t M -
r
,

since v10 ) = 0 > r = ✓ (1)

,

Rewriting it as v11) tm -

rz = V12 ) tm fr, -

Rearranging it to rz = v12 ) -
v11 )

The reservation price the third unit V13 ) V12 )

for of consumption is
by rz
-

given =
 otes Week 6
23 September 2021

Reservation prices measure the marginal utilities associated with different levels of consumption of good 1, assumption of convex

preferences implies that the sequence of reservation prices must decrease :

rn > rz > B. . .

because the special the amount of

> . . . structure of the quasi linear utility function ,
the reservation prices do not depend on

good 2 that the consumer has

exp given any price (p ) , just find where it in the list

> . . .
we falls of reservation prices
•
p falls between rb and ra
r, > P means that the consumer is willing to give up p dollars per unit bought to
get 6 units of good 1

p > rp means that the consumer is not willing to give up p dollars per unit to get the 7th unit of good 1

the consumer demands 6 units of good 1 > rb I P I try

maximizing utility : v16 ) + m -

6P I vlx , ) t m -
px ,

for all possible choices of v16) GP I v15) SP v16) v15) I p

× : 1- m +m > r, > v16) +m top I V17 ) 7- p
-
= tm
-
,
-
- -

rearranged as p 2 v17) -
v16) =
rz

• Substitutes and complements

Imperfect substitutes for example ,

pens S Pencils to some degree is a substitute for each other, although they are not as perfect a substitute for
each other

Imperfect complements for example , a pair of shoes s socks are usually consumed together ,
but not always

> mechanism : demand function X, (P, Pz , ,

m
)
• Substitutes if the demand for good
,
1 goes up when the price of good 2 goes up

×'
Rate of Exchange : > 0
✗2

good 2 gets more expensive , the consumer switches to consuming good 1 ( substituting away from the more expensive to cheaper )
aa
Complements if ,
the demand of good 1
goes down when the price of good 2
goes up

×'
Rate of Exchange : < 0
✗2

Complements are
goods that are consumed together . thus if price of one good rises , the consumption of both goods will tend to

decrease

> Notes
×'
perfect substitutes .
/ is positive (or Zero )
×,
×'
perfect complements ,
/ ×,
is negative
Gross substitutes situation , involving more than two goods where good 1
may be a substitute for good 3

Gross complements good ,

3
may be a complement for good 1

• The inverse demand function

If we hold Pz Sm fixed and plot p, against ×, we get the demand curve with downward slopes so that higher prices lead to

less demand

Inverse demand function is the demand function viewing price as a function of quantity, for each level of demand for good 1 , the

inverse demand function measures what the price of good 1 would have to be in order for the consumer to choose that level of

consumption

> measures the same relationship as the direct demand function

P,
inverse demand
curve Palin ) Direct demand function, Cobb Douglas demand for good -
1 , Xi = amlp,
Inverse demand function
am
/×
,
relationship between price and quantity ,
P, =
,

Xp
 otes Week 6
23 September 2021

The optimal choice must satisfy the condition that the absolute value of the MRS equals the price ratio

R
MRS =

pz
at the optimal level of demand for 1 P, / MRS 1Pa
good : =
, the price of good 1 is proportional to the absolute value of the MRS
between good 1 and good 2

at the optimal level of demand the price good 1 how much the consumer is to in order to
, of measures
willing give up of good 2

get a little more of good 1

The inverse demand function is the absolute value of
simply measuring the MRS,
any optimal level of ×, the inverse demand

function tells how much of good 2 the consumer would want to have to compensate him for a small reduction in the amount of

good 1

> also measures how much the consumer 2 to make him

would be willing to sacrifice of good just indifferent to
having a little more of
good 1

> if good 2 is being the money to spend on other goods S MRS as

being how many dollars the individual would be willing to give up to

have a little more of good 1

• MRS measuring the

as
marginal willingness to pay , price 1 is just the MRS

price of good 1 is
measuring the marginal willingness to pay

Demand curve ,
the new meaning of the downward sloping
> ×, is very small the ,
consumer is willing to give up a lot of money to acquire a little bit more of good 1

> ×, is larger ,
the consumer is willing to give up less
money on the margin to acquire a little more of good 1
The marginal willingness to sacrifice good 2 for good 1 is
decreasing as we increase the consumption of good 1