Transcript 9-46 Why is the demand curve downward sloping?

WHY DOES THE
DEMAND CURVE
SLOPE
DOWNWARD?
READ Krugman Section 9, Module 46
Mankiw Ch 4, 5, 6
DO Morton Unit 2
REASONS FOR THE DOWNWARD
SLOPING DEMAND CURVE
INCOME EFFECT: the change in consumption
that results from the movement to a higher
indifference curve.
SUBSTITUTION EFFECT: the change in
consumption that results from being on an
indifference curve with a marginal rate of
substitution.
THE INCOME EFFECT
Suppose a consumer makes $1000 a month and spends
all of his money on either Pizza or Pepsi.
The graph
shows the
amount the
consumer
could afford if
the price of
Pepsi is $2
and the price
of pizza is $10.
Q of
Pepsi
500
100
Q of
Pizza
THE INCOME EFFECT
The point where he spends exactly $500 on each is:
Because slope is:
Q of
Pepsi
Vertical distance
This line is called
budget constraint.
500
Horizontal distance
This would mean
500/100 or
250
5 pepsi to 1 pizza.
(We ignore the minus sign.)
50
100
Q of
Pizza
Draw the budget constraint for a
person with income of $1000 if
the price of Pepsi is $5 and the
price of pizza is $10.
THE SUBSTITUTION
EFFECT
An indifference curve shows the bundles of
consumption that make the consumer equally happy.
Q of
Pepsi
In this case, the
indifference
curves show the
combinations of
Pepsi and pizza
it would take to
make the
consumer
happy.
C
B
D
I2
A
I1
Q of
Pizza
A substitute good is defined as a
good that, when its price rises
causes a increase in the demand
of another good (or visa versa).
Substitute goods have a direct
relationship between price of one
good and demand for another.
Pa
Db
Pa
Db
A complementary good is defined as a
good that, when its price rises causes
a decrease in the demand of another
good (or visa versa).
Complementary goods have an
inverse relationship between price of
one good and demand for another.
Pa
Db
Pa
Db
THERE ARE FOUR
PROPERTIES OF THE
INDIFFERENCE CURVE
1) Higher indifference curves are
preferred to lower ones.
Consumers
usually prefer
more to less.
Therefore, a
consumer would
prefer point D to
point A because
it is on a higher
indifference
curve.
Q of
Pepsi
C
B
D
I2
A
I1
Q of
Pizza
2) Indifference curves are downward
sloping.
The IC reflects the Q of
rate at which
Pepsi
consumers are
willing to substitute
one good for
another. Therefore,
if Q of one good is
reduced, then the Q
of the other must
increase to make the
consumer equally
happy.
C
B
D
I2
A
I1
Q of
Pizza
3) Indifference curves do not cross.
This could never
Q of
happen.
According to these Pepsi
indifference
curves, the
consumer would
be equally happy
at points A, B, and
C, even though
point C has more
of both goods.
A
C
B
Q of
Pizza
4) Indifference curves are bowed inward.
This shape
implies that the
marginal rate of
substitution
(MRS) depends
on the Q of the
two goods the
consumer is
consuming.
When IC are less
bowed, the
goods are easy
to substitute for
each other.
Q of
Pepsi
MRS = 6
14
B
8
MRS = 1
4
A
3
I1
2
3
6
7
Q of
Pizza
The effect of a price change can be broken down in to
the income effect and the substitution effect.
Point A is the
initial optimum,
and the
movement along
the IC to point B
represents the
Substitution
Effect.
The Income Effect
is shown in the
movement from
point B to point C.
Q of
Pepsi
C
B
A
Q of
Pizza
To derive the DEMAND CURVE, notice that when the
price of Pepsi falls from $2 to $1…….
the consumer’s
optimum
moves from
point A to B,
and the
optimum
quantity of
Pepsi
consumed
rises from 250
to 750.
Q of
Pepsi
750
250
B
A
Q of
Pizza
Therefore, the demand curve reflects this relationship
between price and quantity.
Price of
Pepsi
A
$2
B
$1
250
750
Quantity
of Pepsi
PowerPoint created by Virginia Meachum
Source: Principles of Economics,
Third Edition, by N. Gregory Mankiw.