Transcript U 1

Chapter 3
Individual Demand
Curves
© 2006 Thomson Learning/South-Western
Demand Functions

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Knowing person’s preferences and all
economic forces that affect choices allows
prediction of how much of each good
person would choose in face of scarcity
Summarizes this information in demand
function: representation of how quantity
demanded depends on prices, income,
and preferences.
Demand Function
Quantity of X demanded  d x ( PX , PY , I ; preferences) {3.1}

Three elements determine quantity
demanded:
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Prices of X and Y
Income (I)
Person’s preferences for X and Y.
Preferences appear to right of semicolon-assume that preferences do not change
during analysis (static)
Changes in Income

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When income increases and prices remain
same, quantity of each good purchased
might increase.
Shown in Figure 3-1 where increase in
income shows as shift of budget line
outward from I1 to I2 to I3.
Slope of budget lines remain same
because prices have not changed .
FIGURE 3-1: Effect of Increasing Income
on Quantities of X and Y Chosen
Quantity of Y
per week
Y1
U1
I1
0
5
X1
Quantity of X
per week
FIGURE 3-1: Effect of Increasing Income
on Quantities of X and Y Chosen
Quantity of Y
per week
Y2
U2
Y1
U1
I1
0
6
X1 X2
I2
Quantity of X
per week
FIGURE 3-1: Effect of Increasing Income
on Quantities of X and Y Chosen
Quantity of Y
per week
Y3
Y2
U3
U2
Y1
U1
I1
0
7
X1 X2 X3
I2
I3
Quantity of X
per week
Changes in Income
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Response to increased income: quantity of
X purchased increases from X1 to X2 and
X3 while the quantity purchased of Y also
increases from Y1 to Y2 to Y3.
Income increases allow more
consumption, reflected in outward shift in
budget constraint. Allows increase in
overall utility.
Normal Goods & Inferior Goods
9
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Normal good: bought in greater quantities
as income increases
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Inferior good: bought in smaller
quantities as income increases.
FIGURE 3-2: Indifference Curve Map
Showing Inferiority
Quantity of Y
per week
Y1
0
10
U1
Z1
I1
Quantity of Z
per week
FIGURE 3-2: Indifference Curve Map
Showing Inferiority
Quantity of Y
per week
Y2
U2
Y1
0
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Z2 Z1
U1
I1
I2
Quantity of Z
per week
FIGURE 3-2: Indifference Curve Map
Showing Inferiority
Quantity of Y
per week
Y3
U3
Y2
U2
Y1
0
12
Z3 Z2 Z1
U1
I1
I2
I3
Quantity of Z
per week
Changes in Good’s Price
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Change in price of one good causes both
slope and intercept of budget line to
change.
Change in one good’s price creates new
utility-maximizing choice on another
indifference curve with a different MRS.
Change in quantity demanded of good
with price change
Substitution Effect

Part of change in quantity demanded for other
goods caused by substitution of one good for
another: called substitution effect
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Movement along an indifference curve
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Consumption has to change to equate MRS
to new price ratio of two goods.
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Income Effect
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Price change creates difference in real
purchasing power; consumers move to
new indifference curve consistent with
new purchasing power
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Part of change in quantity demanded
caused by change in real income: called
income effect.
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Substitution and Income Effects
from a Fall in Price
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Figure 3-3: when price of good X falls,
budget line rotates out from unchanged Y
axis such that X intercept lies farther out-consumer can now buy more X with lower
price.
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Flatter slope means that relative price of X
to Y (PX/PY) has fallen.
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FIGURE 3-3: Income and
Substitution Effects of a Fall in Price
Quantity of Y
per week
Y*
U1
0
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X*
Quantity of X
per week
FIGURE 3-3: Income and
Substitution Effects of a Fall in Price
Quantity of Y
per week
Old budget constraint
Y*
B
New budget constraint
U1
0
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X*
XB
Substitution
effect
Quantity of X
per week
FIGURE 3-3: Income and
Substitution Effects of a Fall in Price
Quantity of Y
per week
Old budget constraint
Y**
Y*
U2
B
New budget constraint
U1
0
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X*
XB X**
Substitution Income
effect
effect
Total increase in X
Quantity of X
per week
FIGURE 3-4: Relative Size of
Substitution Effects
Right Shoes
Exxon
.
A,B
U1
I
I
I’
I’
U1
Mobil
Left Shoes
(a) Small Substitution
’
Effect
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(b) Large Substitution Effect
Substitution and Income Effects
from an Increase in Price
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Increase in PX will shift budget line in toward
origin, as in Figure 3-5.
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Substitution effect, holding “real” income
constant: move on U2 from X*, Y* to point B
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Because higher price decreases purchasing
power, movement from B to X**, Y** is income
effect
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FIGURE 3-5: Income and Substitution
Effects of an Increase in Price
Quantity of Y
per week
U2
New budget constraint
Y*
Old budget constraint
0
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X*
Quantity of X
per week
FIGURE 3-5: Income and Substitution
Effects of an Increase in Price
Quantity of Y
per week
U2
U1
B
New budget constraint
Y*
Old budget constraint
0
XB
X*
Substitution
effect
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Quantity of X
per week
FIGURE 3-5: Income and Substitution
Effects of an Increase in Price
Quantity of Y
per week
U2
U1
B
Y**
New budget constraint
Y*
Old budget constraint
0
X** XB
X*
Income Substitution
effect
effect
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Total reduction
in X
Quantity of X
per week
Substitution and Income Effects
for a Normal Good: Summary
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Figures 3-3 and 3-5 show that substitution
and income effects work in the same
direction with a normal good.
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When price falls, both substitution and
income effects result in more purchased.
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When price increases, both substitution and
income effects result in less purchased.
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Substitution and Income Effects
for a Normal Good: Summary
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These effects provide rationale for
downward sloping demand curves.
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Also help to determine steepness of
demand curve
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If either substitution or income effects are
large, change in quantity demanded will
be large with given price change.
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Substitution and Income Effects
for Inferior Goods
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With inferior good, substitution and
income effects work in opposite directions.
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Substitution effect results in decreased
consumption for price increase and
increased consumption for price decrease.
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Substitution and Income Effects
for Inferior Goods
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For inferior goods, income effect results in increased
consumption for price increase and decreased
consumption for price decrease.
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Figure 3-6 shows income and substitution effects for
increase in PX.
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Substitution effect, holding real income constant,
appears as move from X*, Y* to point B both on U2.
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FIGURE 3-6: Income and Substitution
Effects for Inferior Good
Quantity of Y
per week
Y*
U2
Old budget constraint
0
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X*
Quantity of X
per week
FIGURE 3-6: Income and Substitution
Effects for Inferior Good
Quantity of Y
per week
B
New budget constraint
Y*
U2
Old budget constraint
Y**
0
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U1
X*
Quantity of X
per week
FIGURE 3-6: Income and Substitution
Effects for Inferior Good
Quantity of Y
per week
B
New budget constraint
Y*
U2
Old budget constraint
Y**
0
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U1
X**
X*
Quantity of X
per week
Substitution and Income Effects:
Inferior Goods
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Income effect reflects reduced purchasing
power due to price increase.
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X is inferior good: decreased income
results in increased consumption of X-shown by move from point B on U1 to new
utility maximizing point X**, Y** on U1.
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Substitution and Income Effects
for Inferior Goods
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Since X** is less than X* ,X price increase
results in decreased consumption of X.
Decreased consumption happens
because the substitution effect, in this
example, is bigger than income effect.
Thus, if the substitution effect dominates,
the demand curve is negatively sloped.
Giffen’s Paradox
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If income effect of price change for an
inferior good is strong enough, quantity
demanded may change in same
direction as price change.
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Situation in which increase in good’s
price leads people to consume more of
the good is called Giffen’s paradox.
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The Lump Sum Principle
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“Lump-sum principle” holds that taxes
imposed on general purchasing power will
have smaller welfare costs than will taxes
imposed on narrow selection of
commodities.
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Consider Figure 3-7: individual initially has
I dollars to spend and chooses to
consume X* and Y* , yielding U3 utility.
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FIGURE 3-7: The Lump-Sum
Principle
Quantity of Y
I
Y*
U3
X*
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Quantity of X
per week
The Lump Sum Principle
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Tax on only good X raises its price,
resulting in budget constraint I* and
consumption reduced to X1, Y1 and utility
level U1.
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General income tax that generates same
total tax revenue is represented by budget
constraint I** that goes though X1, Y1.
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FIGURE 3-7: The Lump-Sum
Principle
Quantity of Y
I
Y1
Y*
Y2
I’
U3
U1
X1
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X*
Quantity of X
per week
FIGURE 3-7: The Lump-Sum
Principle
Quantity of Y
I
Y1
Y*
Y2
I’
I”
U3
U2
U1
X1
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X2 X*
Quantity of X
per week
The Lump Sum Principle
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Intuitive explanation of lump-sum principle:
single-commodity tax affects consumers in two
ways:
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Reduces purchasing power,
Directs consumption away from good being taxed.
The lump-sum tax only has first of these two
effects.
Changes in the Price of Another
Good
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In two-good economy, when price of one
good changes, affects demand for other
good.
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Figure 3-3: increase in price of X (a
normal good) caused both income and
substitution effect that caused reduction in
quantity demanded of X.
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Changes in the Price of Another Good
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In addition, substitution effect caused
demand decrease for good Y as
consumer substituted good X for good Y.
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To offset, purchasing power increase
brought about by price decrease causes
an increase in demand for good Y (also
normal good).
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Changes in the Price of Another Good
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In this case, income effect had dominant
effect on good Y--consumption of Y
increased due to decrease in X’s price.
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With flatter indifference curves as shown
in Figure 3-8, situation reverses.
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Decrease in X’s price causes decrease in
consumption of good Y, as before.
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FIGURE 3-8: Effect on the Demand for Good
Y of a Decrease in the Price of Good X
Quantity of Y
per week
Old budget constraint
Y*
U1
0
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X*
Quantity of X
per week
FIGURE 3-8: Effect on the Demand for Good
Y of a Decrease in the Price of Good X
Quantity of Y
per week
Old budget constraint
A
Y*
B
New budget constraint
U2
U1
0
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X*
Quantity of X
per week
FIGURE 3-8: Effect on the Demand for Good
Y of a Decrease in the Price of Good X
Quantity of Y
per week
Old budget constraint
A
Y*
Y**
B
C
New budget constraint
U2
U1
0
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X*
X**
Quantity of X
per week
Changes in the Price of Another Good –
Substitutes & Complements
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Here, income effect much smaller than
substitution effect, so consumer ends up
consuming less of good Y at Y** after
decrease in X’s price.
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Thus, effect of change in the price of one
good has an ambiguous effect on demand
for the other good.
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Construction of Individual
Demand Curves
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Individual demand curve: graphic
representation between price of good and
quantity demanded by consumer, holding all
other factors (preferences, prices of other
goods, and income) constant
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Demand curves limit the study to the
relationship between the quantity demanded
and changes in the good’s price—a singlegood world
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Construction of Individual
Demand Curves
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Panel a of Figure 3-9: individual’s
indifference curve map drawn using three
different budget constraints--Px decreases
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Decreasing prices: P’X, P”X, and P’’’X
respectively
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Individual’s utility maximizing choices of
quantity of X: X’, X’, and X’’’ respectively
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FIGURE 3-9: Construction of Individual’s
Demand Curve
Quantity of Y
per week
Budget constraint for9P
X
U1
0
X’
Quantity of X
per week
(a) Individual’s indifference curve map
Price
P’X
0
X’
Quantity of X
per week
(b) Demand curve
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FIGURE 3-9: Individual’s Demand Curve
Quantity of Y
per week
Budget constraint for P’X
Budget constraint for P’’X
U2
U1
0
X’
X”
X’”
Quantity of X
per week
(a) Individual’s indifference curve map
Price
P’X
P’’X
0
X’
X”
Quantity of X
per week
(b) Demand curve
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FIGURE 3-9: Individual’s Demand Curve
Quantity of Y
per week
Budget constraint for P’X
Budget constraint for P’’X
Budget constraint for P’’’X
U3
U2
U1
0
X’
X”
X’”
Quantity of X
per week
(a) Individual’s indifference curve map
Price
P9
X
P0
X
PX
0
X’
X”
X’”
(b) Demand curve
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Quantity of X
per week
FIGURE 3-9: Construction of an
Individual’s Demand Curve
Quantity of Y
per week
Budget constraint for P’X
Budget constraint for P’’X
Budget constraint for P’’’X
U3
U2
U1
0
X’
X”
X’”
Quantity of X
per week
(a) Individual’s indifference curve map
Price
P9
X
P0
X
PX
d
0
X’
X”
X
X’”
(b) Demand curve
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Quantity of X
per week
Constructing Individual Demand Curves
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Three choices show that quantity of X
demanded increases as PX falls.

Panel b shows how we can use three
price and quantity choices to
construct demand curve.
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Constructing Individual Demand Curves

PX appears on vertical axis; QdX shown on
horizontal axis.

Demand curve (dX) downward sloping: when
PX falls, QdX increases.

This result follows from substitution and
income effects (as shown in ch. 2).
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Shape of the Demand Curve

If good X has close substitutes, increase
in its price will cause large decrease in
quantity demanded: substitution effect will
be large.
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Demand curve for a type of breakfast cereal
will likely be relatively flat due to strong
substitution effect.
Shape of the Demand Curve

If good X has few substitutes, substitution
effect of price increase or decrease will be
small and demand curve will be relatively
steep.
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Water--good with few substitutes.
Shape of the Demand Curve
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Food as a category has no substitutes;
might be thought that no change in
consumption would occur with a price
increase.
Food constitutes large part of individual’s
budget: price changes may cause
relatively larger effects on quantity
demanded due to income effect.
Shifts in an Individual’s Demand
Curve

When one variable that had been held constant
(price of another good, income or preferences)
changes, the entire demand curve shifts.

Figure 3-10 shows kinds of shifts that might take
place.
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If X is normal good and income increases,
demand increases as shown in Panel a.
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FIGURE 3-10: Shifts in Individual’s
Demand Curve
PX
PX
P1
P1
P1
0
X1
(a)
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PX
X2
X
0
X1 X2
(b)
X
0
X2
X1
(c)
X
FIGURE 3-10: Shifts in Individual’s
Demand Curve
PX
PX
P1
P1
P1
0
X1
(a)
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PX
X2
X
0
X1 X2
(b)
X
0
X2
X1
(c)
X
Shifts in Individual’s Demand Curve

If X and Y are substitutes and PY
increases, dX increases: shown in Panel b.

Alternatively, if X and Y are complements,
PY increase will cause dX decrease: shown
in Panel c.
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Shifts in Individual’s Demand Curve
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Preference changes can also shift
demand curves.
Panel b could represent increased
preference for cold drinks when sudden
hot spell occurs.
Increased environmental consciousness
during the 1980’s and 1990s increased
demand for recycling and for organic food.
Be Careful in Using Terminology:
Essential Distinctions

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A movement downward along a stationary
demand curve in response to a fall in price is
called an increase in quantity demanded
while a rise in the price of the good results in
a decrease in quantity demanded.
A rightward shift in a demand curve is called
an increase in demand while a leftward
shift is a decrease in demand.
Consumer Surplus
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Fig. 3-11 shows demand curve for T-shirts.
At PT of $11, individual chooses to buy ten
T-shirts.
In other words, the individual is willing and
able to pay $11 for the tenth T-shirt.
With PT of $9, individual buys fifteen Tshirts; implicit value of fifteenth shirt only
$9.
Consumer Surplus

Because good usually sold at single market price,
people choose to buy additional units of the good up
to the point at which their marginal valuation equals
the good’s price (from chapter 2).

Figure 3-11, PT= $7: individual will buy twenty shirts
because twentieth T-shirt is worth precisely $7.

Person will not buy the twenty-first T-shirt, because
its worth is less than $7.
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Graphical Illustration of Consumer Surplus

Graphically, consumer surplus given
by area below demand curve and
above market price.

Figure 3-11: total consumer surplus is
given by area AEB ($80).
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FIGURE 3-11: Consumer Surplus
from T-Shirt Demand Price ($/shirt)
Price (PT= $/shirt)
15 A
11
9
E
B
d
10
68
15
20
Quantity
(shirts)
Consumer Surplus and Utility

Figure 3-12: individual willing to pay BC
for right to consume T-shirts rather than
spending I only on other goods.

Would need to be compensated by AB in
other goods to maintain utility at U1
69
FIGURE 3-12: Consumer Surplus
and Utility
Price ($/shirt)
A
B
C
E
U1
I
U0
I’
20
70
Quantity
(shirts)