© 2009 Pearson Education Canada 4/1 Chapter 4 More Demand Theory

© 2009 Pearson Education Canada4/1

Chapter 4Chapter 4

More Demand TheoryMore Demand Theory


The Law of DemandThe Law of Demand

The The law of demandlaw of demand implies an implies an inverse relationship between price inverse relationship between price and quantity demanded.and quantity demanded.

When the price and quantity of a When the price and quantity of a good are positively related, the good good are positively related, the good is called a is called a Giffen GoodGiffen Good..


Income and Substitution EffectsIncome and Substitution Effects

The The substitution effectsubstitution effect of a change of a change in pin p11 is associated with is associated with the relative the relative change in the pricechange in the price of good 1. of good 1.

The The income effectincome effect of a change in of a change in pp11

is associated with the is associated with the change in change in real real income.income.


Figure 4.1 A Giffen goodFigure 4.1 A Giffen good


Figure 4.2 Income and substitution Figure 4.2 Income and substitution effects for a price increaseeffects for a price increase


Figure 4.3 Income and substitution Figure 4.3 Income and substitution effects for a price decreaseeffects for a price decrease


Income and Substitution EffectsIncome and Substitution Effects

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

For a For a normal goodnormal good, the income effect is , the income effect is negatively related to the price change.negatively related to the price change.

For an For an inferior goodinferior good, the income effect is , the income effect is positively related to the price change.positively related to the price change.


Compensatory IncomeCompensatory Income

After a price change, the minimum After a price change, the minimum income that allows the consumer to income that allows the consumer to attain the original indifference curve attain the original indifference curve is called the compensatory income.is called the compensatory income.

The budget line associated with the The budget line associated with the compensatory income is the compensatory income is the compensated budget linecompensated budget line..


Figure 4.4 The nonpositive Figure 4.4 The nonpositive substitution effectsubstitution effect


The Compensated Demand CurveThe Compensated Demand Curve

The The compensated demand curvecompensated demand curve identifies the consumer’s utility identifies the consumer’s utility maximizing bundle when, as a result maximizing bundle when, as a result of a price change, the consumer’s of a price change, the consumer’s income is adjusted to keep him/her income is adjusted to keep him/her on the same indifference curve.on the same indifference curve.

The compensated demand curve The compensated demand curve reflects the substitution effect and reflects the substitution effect and cannot be upward sloping.cannot be upward sloping.


Figure 4.5 The compensated demand curveFigure 4.5 The compensated demand curve


Compensating and Equivalent VariationCompensating and Equivalent Variation

Equivalent variationEquivalent variation identifies the identifies the variation in income that is equivalent variation in income that is equivalent to being able to buy good x at a to being able to buy good x at a given price.given price.

Compensating variationCompensating variation identifies identifies the variation in income that the variation in income that compensates for the right to buy compensates for the right to buy good x at a given price.good x at a given price.


Figure 4.8 Measuring the benefit of a new goodFigure 4.8 Measuring the benefit of a new good


From Figure 4.8 From Figure 4.8 Mr. Polo’s non-member initial Mr. Polo’s non-member initial

equilibrium is Eequilibrium is E0 0 on Ion I00.. Equilibrium as a member is EEquilibrium as a member is E1 1 on Ion I11.. Equivalent variation is EV. With no Equivalent variation is EV. With no

membership, this additional income membership, this additional income would yield indifference curve Iwould yield indifference curve I11..

Compensating variation is CV. Given Compensating variation is CV. Given that he is a member, this reduction in that he is a member, this reduction in income yields indifference curve Iincome yields indifference curve I0.0.


Figure 4.9 Measuring the cost of a price changeFigure 4.9 Measuring the cost of a price change


From Figure 4.9From Figure 4.9

Low price of PLow price of P11 gives equilibrium of E gives equilibrium of E0 0

on Ion I00..

Equilibrium with higher price of PEquilibrium with higher price of P11 is is at Eat E1 1 on Ion I11..

With a lower price, reducing income With a lower price, reducing income by EV yields Iby EV yields I11..

With a higher price, increasing With a higher price, increasing income by CV would yield Iincome by CV would yield I00..


Figure 4.10 The case in which CV equals EVFigure 4.10 The case in which CV equals EV


Figure 4.11 Figure 4.11 Consumer’s surplusConsumer’s surplus for a new good for a new good


Figure 4.12 Consumer’s surplus Figure 4.12 Consumer’s surplus for a price reductionfor a price reduction


Figure 4.13 Marginal values and Figure 4.13 Marginal values and marginal rates of substitutionmarginal rates of substitution


Figure 4.14 Figure 4.14 Total valueTotal value and marginal value and marginal value


Figure 4.15 Equal marginal valuesFigure 4.15 Equal marginal values


Application: Two Part TariffApplication: Two Part Tariff

What combination of camera price What combination of camera price (p(pcc) and film price (p) and film price (p11) maximize ) maximize profits?profits?

The cost of producing a camera is $5, The cost of producing a camera is $5, the cost of making film is 1$.the cost of making film is 1$.

The firm’s profit maximizing strategy The firm’s profit maximizing strategy is to sell the film at cost and charge is to sell the film at cost and charge the corresponding reservation price the corresponding reservation price for the camera, area GAF (Fig 4.16).for the camera, area GAF (Fig 4.16).


Figure 4.16 The Polaroid pricing problemFigure 4.16 The Polaroid pricing problem


Figure 4.17 The Paasche quantity indexFigure 4.17 The Paasche quantity index


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Figure 4.18 An index-number puzzleFigure 4.18 An index-number puzzle

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© 2009 Pearson Education Canada 4/1 Chapter 4 More Demand Theory