Demand Function

• The optimal choice of goods 1 and 2 at some set of prices and income is called
the consumer’s demanded bundle.
• The demand function is the function that relates the optimal choice—the
quantities demanded—to the different values of prices and incomes.
• Demand function for X(Px, Py, M) and Y(Px, Py, M).
• Different preferences will lead to different demand functions

Examples
● perfect substitutes

● perfect compliments

• If the demand for each good increases with increase in income then such
commodity is known as a normal commodity ΔX/ΔM > 0.
What about the reverse?
ΔX/ΔM < 0?
INCOME AND SUBSTITUTION EFFECTS

A fall in the price of a good has two effects::

1. Consumers will tend to buy more of the good that has become cheaper
and less of those goods that are now relatively more expensive.

2. Because one of the goods is now cheaper, consumers enjoy an increase

in real purchasing power.

Substitution Effect
● substitution effect Change in consumption of a good associated with
a change in its price, with the level of utility held constant.

Income Effect
● income effect Change in consumption of a good resulting from an
increase in purchasing power, with relative prices held constant.

The total effect of a change in price is given theoretically by the sum of the
substitution effect and the income effect:
Total Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2)
INCOME AND SUBSTITUTION EFFECTS

Figure 4.6
Income and Substitution Effects:
Normal Good

A decrease in the price of food

has both an income effect and a
substitution effect.
The consumer is initially at A, on
budget line RS.
When the price of food falls,
consumption increases by F1F2 as
the consumer moves to B.
The substitution effect F1E
(associated with a move from A to
D) changes the relative prices of
food and clothing but keeps real
income (satisfaction) constant.
The income effect EF2
(associated with a move from D to
B) keeps relative prices constant
but increases purchasing power.
Food is a normal good because
the income effect EF2 is positive.
Income Effect and inferior goods

Figure 4.7
Income and Substitution Effects: Inferior
Good

The consumer is initially at A on

budget line RS.
With a decrease in the price of food,
the consumer moves to B.
The resulting change in food
purchased can be broken down into a
substitution effect, F1E (associated
with a move from A to D), and an
income effect, EF2 (associated with a
move from D to B).
In this case, food is an inferior good
because the income effect is
negative.
However, because the substitution
effect exceeds the income effect, the
decrease in the price of food leads to
an increase in the quantity of food
demanded.
A Special Case: The Giffen Good

● Giffen good Good whose demand curve slopes upward because the
(negative) income effect is larger than the substitution effect.

Figure 4.8
Upward-Sloping Demand Curve: The
Giffen Good

When food is an inferior good, and

when the income effect is large
enough to dominate the
substitution effect, the demand
curve will be upward-sloping.
The consumer is initially at point
A, but, after the price of food falls,
moves to B and consumes less
food.
Because the income effect F2F1 is
larger than the substitution effect
EF2, the decrease in the price of
food leads to a lower quantity of
food demanded.
Slutsky Decomposition- Normal commodity (price fall)
Slutsky Decomposition- Inferior non giffen (price fall)
Slutsky Decomposition- Giffen Commodity(price fall)
Questions for Practice 1

1. Show the income and substitution effect when there is and increase in prices
of normal goods.
2. Show the income and substitution effect when there is and increase in prices
of inferior goods.
3. Show the income and substitution effect when there is and increase in prices
of giffen goods.
Price consumption curve and Individual Demand

The Individual Demand Curve

● price-consumption curve Curve tracing the utility-maximizing
combinations of two goods as the price of one changes.
● individual demand curve Curve relating the quantity of a good that a
single consumer will buy to its price.
The Individual Demand Curve
Figure 4.1
Effect of Price Changes

A reduction in the price of food, with income and the

price of clothing fixed, causes the consumer to choose
a different market basket.

The utility maximizing combination of 6 units of clothing

and 4 units of food corresponds to a price of food equal
to $2.00.

In panel (a), as the price of food falls, the utility

maximizing combination changes.

The baskets that maximize utility for various prices

of food trace out the price-consumption curve.

As the price of food changes, the quantity

of food demanded changes. The
relationship between the price and the
quantity of food demanded, shown in panel
(b), traces the demand curve for food.
Income consumption curve and Individual Demand

Income Changes
Figure 4.2

Effect of Income Changes

An increase in income, with the

prices of all goods fixed, causes
consumers to alter their choice of
market baskets.
In part (a), the baskets that
maximize consumer satisfaction
for various incomes (point A,
$10; B, $20; D, $30) trace out the
income-consumption curve.
The shift to the right of the
demand curve in response to the
increases in income is shown in
part (b). (Points E, G, and H
correspond to points A, B, and D,
respectively.)
Normal versus Inferior Goods

Figure 4.3
An Inferior Good

An increase in a person’s
income can lead to less
consumption of one of the
two goods being
purchased.
Here, hamburger, though
a normal good between A
and B, becomes an
inferior good when the
income-consumption
curve bends backward
between B and C.
Engel curve

 Named after the German statistician Ernst Engel 

 An Engel curve describes how household expenditure on a particular
good or service varies with household income. 
 A relation between quantity and Income
 Prices of the commodities remain constant
 For normal goods, the Engel curve has a positive gradient. That is,
as income increases, the quantity demanded increases.
 Amongst normal goods, there are two possibilities. Although the
Engel curve remains upward sloping in both cases, it bends
toward the y-axis for necessities and towards the x-axis
for luxury goods.
 For inferior goods, the Engel curve has a negative gradient. That
means that as the consumer has more income, they will buy less
of the inferior good because they are able to purchase better
goods.
 Engel Curves
● Engel curve Curve relating
the quantity of a good
consumed to income.
Figure 4.4

An Inferior Good

Engel curves relate the

quantity of a good consumed
to income.
In (a), food is a normal good
and the Engel curve is
upward sloping.
In (b), however, hamburger
is a normal good for income
less than $20 per month
and an inferior good for
income greater than $20 per
month.
MARKET DEMAND

● market demand curve Curve relating the quantity of a good that all
consumers in a market will buy to its price.

Substitution Effect

TABLE 4.2 Determining the Market Demand Curve

(1) (2) (3) (4) (5)
Price Individual A Individual B Individual C Market
($) (Units) (Units) (Units) (Units)
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
Figure 4.10
Summing to Obtain a Market Demand
Curve

The market demand curve is

obtained by summing our three
consumers’ demand curves DA, DB,
and DC.
At each price, the quantity of coffee
demanded by the market is the sum
of the quantities demanded by each
consumer.
At a price of $4, for example, the
quantity demanded by the market
(11 units) is the sum of the quantity
demanded by A (no units), B (4
units), and C (7 units).
Substitution Effect
Two points should be noted:
1. The market demand curve will shift to the right as more
consumers enter the market.
2. Factors that influence the demands of many consumers will also
affect market demand.
The aggregation of individual demands into market becomes
important in practice when market demands are built up from the
demands of different demographic groups or from consumers located
in different areas.
For example, we might obtain information about the demand for
home computers by adding independently obtained information about
the demands of the following groups:
• Households with children
• Households without children
• Single individuals
MARKET DEMAND

Domestic demand for wheat is given by the equation

QDD = 1368 - 38P
where QDD is the number of bushels (in millions) demanded
domestically, and P is the price in dollars per bushel. Export demand
is given by
QDE = 1470 − 70P
where QDE is the number of bushels (in millions) demanded from
abroad.
To obtain the world demand for wheat, we set the left side of each
demand equation equal to the quantity of wheat. We
then add the right side of the equations, obtaining
QDD + QDE = (1368 − 38P) + (1470 − 70P) = 2838 − 108P
Speculative Demand
speculative demand Demand driven not by the direct benefits one
obtains from owning or consuming a good but instead by an expectation
that the price of the good will increase.

A very related concept from Macro Economics:

•Liquidity Preference Theory By Keynes
•Also known as Keynes’ Theory of Demand
• 3 motives of demanding money
• Transaction
• Precautionary
• Speculative
CONSUMER SURPLUS

● consumer surplus Difference between what a consumer

is willing to pay for a good and the amount actually paid.
Consumer Surplus and Demand

Figure 4.13
Consumer Surplus

Consumer surplus is the

total benefit from the
consumption of a
product, less the total
cost of purchasing it.

Here, the consumer

surplus associated with
six concert tickets
(purchased at $14 per
ticket) is given by the
yellow-shaded area:

$6 + $5 + $4 + $3 + $2 +
$1 = $21
CONSUMER SURPLUS

Consumer Surplus and Demand

Figure 4.14

Consumer Surplus Generalized

For the market as a whole,

consumer surplus is
measured by the area under
the demand curve and above
the line representing the
purchase price of the good.

Here, the consumer surplus is

given by the yellow-shaded
triangle and is equal to
1/2 × ($20 − $14) × 6500 =
$19,500.
Questions for Practice
1. Explain the difference between PCC and Demand Curve, ICC and Engel
curve, Engel curve and demand curve.

2. An individual sets aside a certain amount of his income per month to spend
on his two hobbies, collecting wine and collecting books. Given the
information below, illustrate both the price-consumption curve associated
with changes in the price of wine and the demand curve for wine.
3. An individual consumes two goods, clothing and food. Given the information
below, illustrate both the income-consumption curve and the Engel curve for
clothing and food.

4. The director of a theater company in a small college town is considering changing

the way he prices tickets. He has hired an economic consulting firm to estimate the
demand for tickets. The firm has classified people who go the theater into two
groups, and has come up with two demand functions. The demand curves for the
general public (Qgp) and students (Qs) are given below:
 a) Graph the two demand curves on one graph, with P on the vertical axis and Q on
the horizontal axis. If the current price of tickets is $35, identify the quantity
demanded by each group.
b) Find the price elasticity of demand for each group at the current price and
quantity.
c) Is the director maximizing the revenue he collects from ticket sales by
charging $35 for each ticket? Explain
d) What price should he charge each group if he wants to maximize revenue
collected from ticket sales?

5. Orange juice and apple juice are known to be perfect substitutes. Draw the
appropriate price consumption curve (for a variable price of orange juice) and
income-consumption curve.
6. Left shoes and right shoes are perfect complements. Draw the appropriate
price-consumption and income-consumption curves.
Marshall vs Hicks
Demand Curve

• Same income, only price change

 Marshall
• Same Utility, only price change
 Hicks (compensated demand)
• the uncompensated demand
curve reflects both income and
substitution effects, the
compensated demand curve
reflects only substitution effects
• Holding income and all other
prices constant  Marshallian
demand curves
• Holding consumer utility
constant  Hicksian demand
function
Marshallian Demand Curve
Holding income and all other prices constant, how does the quantity of good X
demanded change with px? We notate this demand function as dx(px, py, I).
Marshallian demand curves implicitly combine income and substitution
effects. The income effect is the change in consumption that arises if the
consumer’s income falls but if prices stay the same. The substitution effect is the
change in consumption that arises if the prices change but the agent is given
enough income to maintain the same utility they had at the initial prices. They are
net demands that sum over these two conceptually distinct behavioral responses
to price changes.
Hicksian Demand Curve
One can also conceive of a demand curve that is composed solely of substitution
effects. This is called Hicksian demand and it answers the question: Holding
consumer utility constant, how does the quantity of good X demanded change with
px. We notate this demand function as hx(px, py, U). The presence of U as a
parameter in the Hicksian demand function indicates that this function holds
consumer utility constant–on the same indifference curve–as prices change.
Hicksian demand is also called compensated demand. This name follows from
the fact that to keep the consumer on the same indifference curve as prices vary,
one would have to adjust the consumer’s income, i.e., compensate them. For
the analogous reason, the Marshallian demand is called uncompensated demand
Questions for practice
Question for practice

1. Slutsky decomposition for Normal commodity in case of price rise.

2. Slutsky decomposition for Inferior commodity in case of price rise.
3. Slutsky decomposition for Inferior (Non Giffen) commodity in case of
price rise.
References

1. Microeconomics by Pindyck and Rubinfeld (8th Edition). (Topics to be

covered 4.1, 4.2, 4.3, 4.4) (Externalities and Marshallian and Hicksian
Demand Curve from PPT)

2. Intermediate Microeconomics by Hal Varian (Chapter 6 and 8) (please

focus on curves only in ch 8)