Ch 4.

Consumers in the Marketplace Consumption choices change as a function of price and/or income Price increases
Lead to decreases in quantity demanded Lead to pivoting budget line and consumers choosing new consumption point

Contents 1. Income Change

a. Income-Consumption Curve b. Normal/Inferior good

2. Price Change
a. Price-Consumption Curve b. Substitution Effect / Income Effect c. Normal/Inferior/Giffen Good

3. Elasticity
a. Point/Arc Elasticity b. Elasticity and Total Revenue

Changes in Income
Composite good convention Income changes
Result in a parallel shift of the budget line

Increase in income
Cause consumption increase if normal good Cause consumption decrease if inferior good

Suppose the price of X is $2 and the price of Y is $3. Given the following indifference curve mapping, draw an Engel curve graph for X.

EXHIBIT 4.3

Normal and Inferior Goods

Income-Consumption Curve
Assumption that prices fixed Relationship between income and quantity of good consumed
prices of goods consuming and indifference curves are constant

Shape of Income-Consumption Curve

Upward-sloping if good X is normal
If consumer income rises, consumes more of good X

Downward-sloping if good X is inferior

If consumer income rises, consumes less of good X

From this, we can get an Engel Curve

showing the relationship between Income and quantity demanded

EXHIBIT 4.4

Constructing the Engel Curve

Changes in Price
Income and price of good Y remain fixed Y-intercept of budget line unchanged by change in price of X Budget line pivots around y-intercept
Pivots inward if rise in price of X Pivots outward if fall in price of X

Changes in optimum point

Located anywhere along new budget line

Suppose the price of Y is $4 and your income is $30. Given the following indifference curve mapping, generate a demand curve for X.

10

15

Price-Consumption Curve
Locus of optimal bundles when the price of the good on the x-axis changes. This is not a demand curve but the information for a demand curve is here

The Demand Curve

Engel curve vs demand curve
Engel curve: relationship between income and consumption
Plots income on horizontal axis and consumption on the vertical axis

Demand curve: relationship between price and consumption

Plots price on the vertical axis and consumption on the horizontal axis

Constructing the Demand Curve

Derived from indifference curves
Find price of X Draw budget line given income and prices Find tangency between budget line and indifference curve Read off quantity of X Plot point on demand curve relating price to quantity Repeat the process for additional points on the demand curve

Constructing the Demand Curve (P falls)

From this we can get a demand schedule and curve. Assuming Income is constant.

Price 250 200 150

Qd C1 C2 C3

Shape of Demand Curve

Slopes downward If Giffen good, slopes upward Demand and indifference curves cannot be drawn on same graph
Require different axes

Giffen Goods
If price of X increases, quantity demanded decreases
Follows law of demand Then, non-Giffen goods

If price of X increases, quantity demanded increases

Violates law of demand Then, Giffen goods

Giffen goods rare or nonexistent

Using theory of indifference curves indicates exception to law of demand

Non-Giffen Goods and Giffen Goods

Income and Substitution Effects

When the price of a good changes, consumers choose a new bundle. Economists decompose this shift from one bundle to another into two parts: the substitution effect and the income effect.
Substitution effect
Price rises Adjust consumption of goods whose price above marginal value

Income effect
Price rises Can no longer afford previous basket Decrease (increase) consumption if normal (inferior) good

Income and Substitution Effects

Substitution Effect: The change in Qd resulting from a change in the relative price of a good, and assuming the original level of utility is maintained.
Substitution effects are always the opposite (negative) of the price change.

Income Effect: The effect on the quantity demanded that results from the change in the purchasing power of a given income when the price of a good changes.
Income effects can go either way.

Suppose Jane has an income of $40 and the price of Y is $4. (1) Price of X = $2: She consumes 14 X & 3 Y. What is her MV of X? (2) Price of X = $4: She decides to consume 8 X & 2 Y. What is her MV of X? (3) With (9X, 6Y), her MV of X = 1 & she will be as happy as with (14X, 3Y)
Y

3 2 U0 8 9 10 14 15

U1

20 X

Income and Substitution Effects

A: original bundle (with X = XA) C: compensated bundle (with X = XC) B: new optimal bundle (with X = XB)

The substitution effect is the change in X caused by the move from A to C (XA to XC). The income effect is the change in X caused by the move from C to B (XB to XC).

Isolating the Substitution Effect

Suppose given just enough money to offset income effect (Compensated: same indifference curve originally on)
If Px increases, the compensated budget constraint must always be steeper than the original budget constraint. (a negative effect on the consumption of X) If Px were to decrease, the compensated budget constraint must always be flatter than the original budget constraint. (a positive effect on the consumption of X)

the Income Effects

If know how substitution effect changes consumption Can deduce impact of income effect Substitution effects are always the opposite (negative) of the price change. Income effects can go either way.
Price change Price increase Price increase Price decrease Price decrease Income Effect Negative income effect Positive income effect Negative income effect Positive income effect Therefore Normal Good Inferior Good Inferior Good Normal Good

Ordinary Inferior/ Giffen Inferior can be determined by the relative size of Income effect to Substitution effect

Inferior Good (Ordinary & Giffen)

Ordinary: Substitution Effect > Income Effect Giffen: Substitution Effect < Income Effect

Quantity of Y per week

Income and Substitution Effects of a Fall in Price of Good X (Normal Good)

Old budget constraint YB YA YC

B A C
U1
Compensated Budget after subtracting income to put consumer on original indifference curve

U2

New budget constraint after lower price of X

XA

XC

XB

Substitution Income effect effect Total effect

Quantity of X per week

Created by Dr. Michael Nieswiadomy

Quantity of Y per week

Income and Substitution Effects of a Fall in Price of Good X (Inferior Good)

YB

B
U2

Old budget constraint

YA YC

A C
U1

New budget constraint after lower price of X

Substitution effect

XA

XB

XC

Compensated Budget after subtracting income to put consumer on original indifference curve

Income effect Total effect

Quantity of X per week

Created by Dr. Michael Nieswiadomy

Quantity of Y per week

YB

Income and Substitution Effects of a Fall in Price of Good X (Giffen Good)

B
U2 Old budget constraint

YA

New budget constraint after lower price of X

YC

C
U1
Substitution effect

XB XA

XC

Income effect

Compensated Budget after subtracting income to put consumer on original indifference curve

Total effect

Quantity of X per week

Created by Dr. Michael Nieswiadomy

Quantity of Y per week

Income and Substitution Effects of a Rise in Price of Good X (Normal Good)

YC YB
YA

C
B A
U1 U2

New budget constraint after higher price of X Old budget constraint

XB

XC

XA

Compensated Budget after adding income to put consumer on original indifference curve

Income effect Substitution effect Total effect

Quantity of X per week

Created by Dr. Michael Nieswiadomy

Quantity of Y per week

Income and Substitution Effects of a Rise in Price of Good X (Inferior Good)

YC
YA

C
A
U1

New budget constraint after higher price of X Old budget constraint

YB

B
Substitution effect X XA C XB Income effect Total effect

Compensated Budget after adding income to put consumer on original indifference curve

U2

Quantity of X per week

Created by Dr. Michael Nieswiadomy

Quantity of Y per week

YC YA

Income and Substitution Effects of a Rise in Price of Good X (Giffen Good)

C A
U1

New budget constraint after higher price of X Old budget constraint

Compensated Budget after adding income to put consumer on original indifference curve

YB
Substitution effect

U2
XB

XC XA

Income effect Total effect

Quantity of X per week

Created by Dr. Michael Nieswiadomy

the relative size of Income effect to Substitution effect for a good on X axis
Price of X rises Price of X falls

Normal B C

Substitution Effect Income Effect

Normal A S.E.

C I.E.

Inferior (Ordinary) C B A
S.E. I.E.

Inferior (Ordinary) A B C
S.E. I.E.

Inferior (Giffen) C
I.E.

S.E.

Inferior (Giffen) B A
S.E. I.E.

the relative size of Income effect to Substitution effect for a good on Y axis
Price of X rises Price of X falls

Normal C B A

S. E.

I. E.

Normal A B C

S. E.

I. E.

Inferior (Ordinary) I. B E. C S. A E.

Inferior (Ordinary) A S. E. C I. E. B

Why Demand Curves Slope Downward: Normal Goods

Geometric Observations
Increases in price, substitution effect means less consumption Move from compensated line to new line, income falls, consume less of good if normal

Demand curve for normal good

Both effects move consumer leftward Normal goods are not Giffen goods

Why Demand Curves Slope Downward: Inferior Goods

Demand curve for inferior goods
Effects move in opposite directions and not as easily analyzed as normal good Inferior good non-Giffen is substitution effect exceeds income effect Inferior good Giffen if income effect exceeds substitution effect

Size of income effect

Income effect of price change large if good large fraction of consumer expenditures

Giffen goods revisited

Giffen goods are inferior Giffen goods account for a large portion of consumer expenditures However, goods that make up a large portion of your budget are generally normal. Conditions above explain why so rare (or nonexistent)

Example) Beatrice has a monthly income of $100 and buys gasoline (Pg = $2) and a composite commodity Y (Py = $2). Say Beatrice consumes 20 gallons of gas and 30 units of Y each month (lets call that bundle A). In order to reduce our use of foreign oil, the government places a tax on gasoline resulting in a new price for gas of Pg = $4. But to eliminate the hardship of extra taxes, the government decides to give citizens like Beatrice $40 per month. They call this the Gas Tax and Gift Policy (GaTGiP). Will Beatrice be better or worse off after the GaTGiP, Tax and Gift policy? Verbally and using the above graph, explain how you know. Will the tax raise enough revenue to pay for the $40 gift? Explain.

Substitutes/Complements
When PXQY(Complements), [Link]/False: Y could not possibly be an inferior good for you. [Link]/False: X could not possibly be an inferior good for you.

Compensated Demand Curve

Curve showing, for each price, what the quantity demanded would be if the consumer were income-compensated for all price changes (if there were no income effect.) Allows for isolation of substitution effect Confirms that compensated demand curve downward sloping

EXHIBIT 4.12
Price P1=$1 P2=$3 Qd 7 1

Compensated and Uncompensated Demand Curve

Summing Individual Demands to Obtain Market Demand

Elasticity
Anticipate changes in consumer buying habits Prediction about direction of change
If income increases or price falls, consumer buys more

No predictions about magnitude of change

Consumption and expenditures change by how much

An elasticity can be calculated for any relationships between two variables

the price elasticity of demand the income elasticity of demand the cross-price elasticity.

Price Elasticity
If price of the good decreased by one dollar, by how many units would you increase your consumption of X? If price of the good decreased by 1%, by what percent would you increase your consumption of X? %Q Q Slope = = %P
P

Price Elasticity of Demand

Arc Price elasticity:
%Q 100 Q / Q Q ( P2 P %P 100 P / P P 1) P ( P2 P 1) Q (Q2 Q1 ) (Q2 Q1 ) 2

Point Price elasticity:

% Q 100 Q / Q Q P %P 100 P / P P Q
The coefficient on Price of demand function. Ex) Q=22-2P:

Q 2 P

More about Price Elasticity

Demand highly elastic when price elasticity of demand has large absolute value Why one good is more elastic?
Availability of substitutes

More about Price Elasticity

Elasticity e=0 0<e<1 e=1 Demand is considered perfectly inelastic inelastic unit elastic If P increases, then total expenditure... Qd completely increases insensitive to in P Qd highly increases insensitive to in P % in Qd exactly does not change the same as the % in P Qd highly sensitive to in P Qd extremely sensitive to in P decreases decreases

1<e< e=

elastic perfectly elastic

REVENUE/EXPENDITURE AND ELASTICITY

Demand Curve: Qd = 22-2P (or P = 11-.5Qd)
Price Quantity Point Elasticity Total Revenue Elastic?

10 9 8 7 6 5 4 3 2 1

2 4 6 8 10 12 14 16 18 20

20 36 48 56 60 60 56 48 36 20

Income Elasticity
Income elasticity %Q 100 Q / Q Q I =
%I 100 I / I
The coefficient on INCOME of demand function. Ex) Q=1200-16*P+0.2*I :

I Q

Q I I Q

Q 0.2 I

Elasticity eY < 0

Goods are considered Inferior good

0 eY 1
eY > 1

Normal, Necessity
Normal, Luxury

Relationship between Income and Price Elasticity of Demand

Determinants of value of price elasticity of demand
Size of substitution effect Size and direction of income effect
Larger for goods that take up large fraction of income Larger for goods with high income elasticity of demand Income effect depends on whether good normal or inferior
Normal: larger income effect means larger price elasticity of demand Inferior: larger income effect means smaller price elasticity of demand

Cross Elasticity of Demand

Demand for good X affected by change in price of some other good Y
Use cross elasticity of demand to measure size of effect Percent change in consumption of good X divided by the percent change in the price of good Y
Elasticity eQa,Pb > 0 eQa,Pb = 0 eQa,Pb < 0 Goods are considered Substitutes Independent goods Complements

Used to determine level and amount of monopoly power held by certain firms in antitrust cases