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Chapter 4 More Demand Theory

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The Law of Demand


The

law of demand implies an inverse relationship between price and quantity demanded. When the price and quantity of a good are positively related, the good is called a Giffen Good.

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Income and Substitution Effects


The

substitution effect of a change in p1 is associated with the relative change in the price of good 1. The income effect of a change in p1 is associated with the change in real income.

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Figure 4.1 A Giffen good

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Figure 4.2 Income and substitution effects for a price increase

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Figure 4.3 Income and substitution effects for a price decrease

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Income and Substitution Effects


If indifference curves are smooth and convex and if the consumer buys a positive quantity of both goods, then the substitution effect is always negatively related to the price change. For a normal good, the income effect is negatively related to the price change. For an inferior good, the income effect is positively related to the price change.

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Compensatory Income
After

a price change, the minimum income that allows the consumer to attain the original indifference curve is called the compensatory income. The budget line associated with the compensatory income is the compensated budget line.

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Figure 4.4 The nonpositive substitution effect

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The Compensated Demand Curve


The

compensated demand curve identifies the consumers utility maximizing bundle when, as a result of a price change, the consumers income is adjusted to keep him/her on the same indifference curve. The compensated demand curve reflects the substitution effect and cannot be upward sloping.
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Figure 4.5 The compensated demand curve

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Compensating and Equivalent Variation


Equivalent

variation identifies the variation in income that is equivalent to being able to buy good x at a given price. Compensating variation identifies the variation in income that compensates for the right to buy good x at a given price.
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Figure 4.8 Measuring the benefit of a new good

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From Figure 4.8


Mr.

Polos non-member initial equilibrium is E0 on I0. Equilibrium as a member is E1 on I1. Equivalent variation is EV. With no membership, this additional income would yield indifference curve I1. Compensating variation is CV. Given that he is a member, this reduction in income yields indifference curve I0.
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Figure 4.9 Measuring the cost of a price change

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From Figure 4.9


Low

price of P1 gives equilibrium of E0 on I0. Equilibrium with higher price of P1 is at E1 on I1. With a lower price, reducing income by EV yields I1. With a higher price, increasing income by CV would yield I0.
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Figure 4.10 The case in which CV equals EV

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Figure 4.11 Consumers surplus for a new good

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Figure 4.12 Consumers surplus for a price reduction

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Figure 4.13 Marginal values and marginal rates of substitution

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Figure 4.14 Total value and marginal value

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Figure 4.15 Equal marginal values

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Application: Two Part Tariff


What

combination of camera price (pc) and film price (p1) maximize profits? Cost of producing camera is $5, cost of making film is 1$. The firms profit maximizing strategy is to sell the film at cost and charge the corresponding reservation price for the camera, area GAF (Fig 4.16).
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Figure 4.16 The Polaroid pricing problem

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Figure 4.17 The Paasche quantity index

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Paasche Quantity Index


1 1 1 1 1 0 1 0 P ( p x p x ) /( p x p x ) 1 1 2 2 1 1 2 2 1 0 If P exceeds 1 then B is preferred to B

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Laspeyres Quantity Index


0 1 0 1 0 0 0 0 L ( p x p x ) /( p x p x ) 1 1 2 2 1 1 2 2 0 1 If L exceeds 1, then B is preferred to B

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Price Indices
Paache Pr ice Index P ' ( p1x1 p1 x1 ) /( p 0 x1 p 0 x1 ) 11 2 2 1 1 2 2 Laspeyres Pr ice Index L' ( p1x 0 p1 x 0 ) /( p 0 x 0 p 0 x 0 ) 11 2 2 1 1 2 2 When L' is less than 1, then P' is also less than 1, and you are better off in period 1. When P' is greater than 1, then L' is aslo greater than 1, and you are better off in period 0.
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Figure 4.18 An index-number puzzle

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