Ch 4. Consumers in the MarketplaceConsumption choices change as a function of price and/or incomePrice increasesLead to decreases in quantity demandedLead to pivoting budget line and consumers choosing new consumption point

ContentsIncome ChangeIncome-Consumption CurveNormal/Inferior goodPrice Change Price-Consumption CurveSubstitution Effect / Income EffectNormal/Inferior/Giffen GoodElasticityPoint/Arc ElasticityElasticity and Total Revenue

Changes in IncomeComposite good conventionIncome changesResult in a parallel shift of the budget lineIncrease in incomeCause consumption increase if normal good Cause consumption decrease if inferior good

Suppose the price of X is $2 and the price of Y is $3. Given the following indifference curve mapping, draw an Engel curve graph for X.

Y6

4

2

1

3 4

6

9

EXHIBIT 4.3Normal and Inferior Goods

Income-Consumption CurveAssumption that prices fixedRelationship between income and quantity of good consumedprices of goods consuming and indifference curves are constantShape of Income-Consumption CurveUpward-sloping if good X is normalIf consumer income rises, consumes more of good XDownward-sloping if good X is inferiorIf consumer income rises, consumes less of good XFrom this, we can get an Engel Curve showing the relationship between Income and quantity demanded

EXHIBIT 4.4Constructing the Engel Curve

Changes in PriceIncome and price of good Y remain fixedY-intercept of budget line unchanged by change in price of XBudget line pivots around y-interceptPivots inward if rise in price of XPivots outward if fall in price of XChanges in optimum pointLocated anywhere along new budget line

Suppose the price of Y is $4 and your income is $30. Given the following indifference curve mapping, generate a demand curve for X.

Y

4 6 7 910

15

X

Price-Consumption CurveLocus of optimal bundles when the price of the good on the x-axis changes.This is not a demand curve but the information for a demand curve is here

The Demand CurveEngel curve vs demand curveEngel curve: relationship between income and consumptionPlots income on horizontal axis and consumption on the vertical axisDemand curve: relationship between price and consumptionPlots price on the vertical axis and consumption on the horizontal axis

Constructing the Demand CurveDerived from indifference curvesFind price of XDraw budget line given income and pricesFind tangency between budget line and indifference curveRead off quantity of XPlot point on demand curve relating price to quantityRepeat the process for additional points on the demand curve

Constructing the Demand Curve (P falls)From this we can get a demand schedule and curve.Assuming Income is constant.

PriceQd250C1200C2150C3

Shape of Demand CurveSlopes downwardIf Giffen good, slopes upwardDemand and indifference curves cannot be drawn on same graphRequire different axes

Giffen GoodsIf price of X increases, quantity demanded decreasesFollows law of demandThen, non-Giffen goodsIf price of X increases, quantity demanded increasesViolates law of demandThen, Giffen goodsGiffen goods rare or nonexistentUsing theory of indifference curves indicates exception to law of demand

Non-Giffen Goods and Giffen Goods

Income and Substitution EffectsWhen the price of a good changes, consumers choose a new bundle.Economists decompose this shift from one bundle to another into two parts: the substitution effect and the income effect.Substitution effectPrice risesAdjust consumption of goods whose price above marginal valueIncome effectPrice risesCan no longer afford previous basketDecrease (increase) consumption if normal (inferior) good

Income and Substitution EffectsSubstitution Effect: The change in Qd resulting from a change in the relative price of a good, and assuming the original level of utility is maintained.Substitution effects are always the opposite (negative) of the price change.

Income Effect: The effect on the quantity demanded that results from the change in the purchasing power of a given income when the price of a good changes.Income effects can go either way.

Suppose Jane has an income of $40 and the price of Y is $4. (1) Price of X = $2: She consumes 14 X & 3 Y. What is her MV of X? (2) Price of X = $4: She decides to consume 8 X & 2 Y. What is her MV of X?(3) With (9X, 6Y), her MV of X = 1 & she will be as happy as with (14X, 3Y)

Y

6

3

U1

2

U0

8 9 10 14 15 20 X

Income and Substitution EffectsThe substitution effect is the change in X caused by the move from A to C (XA to XC).The income effect is the change in X caused by the move from C to B (XB to XC).

A: original bundle (with X = XA)C: compensated bundle (with X = XC)B: new optimal bundle (with X = XB)

Isolating the Substitution EffectSuppose given just enough money to offset income effect (Compensated: same indifference curve originally on)If Px increases, the compensated budget constraint must always be steeper than the original budget constraint. (a negative effect on the consumption of X)If Px were to decrease, the compensated budget constraint must always be flatter than the original budget constraint. (a positive effect on the consumption of X)

the Income EffectsIf know how substitution effect changes consumptionCan deduce impact of income effectSubstitution effects are always the opposite (negative) of the price change.Income effects can go either way.

Ordinary Inferior/ Giffen Inferior can be determined by the relative size of Income effect to Substitution effect

Price changeIncome EffectThereforePrice increaseNegative income effect Normal GoodPrice increasePositive income effectInferior GoodPrice decreaseNegative income effect Inferior GoodPrice decreasePositive income effectNormal Good

Inferior Good (Ordinary & Giffen) Ordinary: Substitution Effect > Income EffectGiffen: Substitution Effect < Income Effect

Total effectIncome and Substitution Effects of a Fall in Price of Good X (Normal Good)0Quantity of X per weekQuantity of Y per weekOld budget constraintU1XAYANew budget constraint after lower price of XU2XBYBXCASubstitution effectIncome effectBCCompensated Budget after subtracting income to put consumer on original indifference curveCreated by Dr. Michael NieswiadomyYC

Total effectIncome and Substitution Effects of a Fall in Price of Good X (Inferior Good)0Quantity of X per weekQuantity of Y per weekOld budget constraintU1XAYANew budget constraint after lower price of XU2XBYBXCASubstitution effectIncome effectBCCompensated Budget after subtracting income to put consumer on original indifference curveCreated by Dr. Michael NieswiadomyYC

Total effectIncome and Substitution Effects of a Fall in Price of Good X (Giffen Good)0Quantity of X per weekQuantity of Y per weekOld budget constraintU1XAYANew budget constraint after lower price of XU2XBYBXCASubstitution effectIncome effectBCCompensated Budget after subtracting income to put consumer on original indifference curveCreated by Dr. Michael NieswiadomyYC

Total effectIncome and Substitution Effects of a Rise in Price of Good X (Normal Good)0Quantity of X per weekQuantity of Y per weekOld budget constraintU2XBYBNew budget constraint after higher price of XU1XAYAXCASubstitution effectIncome effectBCCompensated Budget after adding income to put consumer on original indifference curveCreated by Dr. Michael NieswiadomyYC

Total effectIncome and Substitution Effects of a Rise in Price of Good X (Inferior Good)0Quantity of X per weekQuantity of Y per weekOld budget constraintU2XBYBNew budget constraint after higher price of XU1XAYAXCASubstitution effectIncome effectBCCompensated Budget after adding income to put consumer on original indifference curveCreated by Dr. Michael NieswiadomyYC

Total effectIncome and Substitution Effects of a Rise in Price of Good X (Giffen Good)0Quantity of X per weekQuantity of Y per weekOld budget constraintU2XBYBNew budget constraint after higher price of XU1XAYAXCASubstitution effectIncome effectBCCompensated Budget after adding income to put consumer on original indifference curveCreated by Dr. Michael NieswiadomyYC

the relative size of Income effect to Substitution effect for a good on X axisPrice of X rises Normal B C A

Inferior (Ordinary) C B A

Inferior (Giffen) C A B

Price of X falls Income EffectSubstitution Effect Normal A C B

Inferior (Ordinary) A B C

Inferior (Giffen)B A C

I.E.S.E.S.E.I.E. S.E.I.E.S.E.S.E.I.E.I.E.

the relative size of Income effect to Substitution effect for a good on Y axisPrice of X rises Normal C B A

Inferior (Ordinary)BCA

Price of X falls I. E.S. E. I. E. S. E.NormalABC

Inferior (Ordinary)ACB

S. E. S. E. I. E. I. E.

Why Demand Curves Slope Downward: Normal GoodsGeometric ObservationsIncreases in price, substitution effect means less consumptionMove from compensated line to new line, income falls, consume less of good if normalDemand curve for normal goodBoth effects move consumer leftwardNormal goods are not Giffen goods

Why Demand Curves Slope Downward: Inferior GoodsDemand curve for inferior goodsEffects move in opposite directions and not as easily analyzed as normal goodInferior good non-Giffen is substitution effect exceeds income effectInferior good Giffen if income effect exceeds substitution effectSize of income effectIncome effect of price change large if good large fraction of consumer expendituresGiffen goods revisitedGiffen goods are inferiorGiffen goods account for a large portion of consumer expendituresHowever, goods that make up a large portion of your budget are generally normal.Conditions above explain why so rare (or nonexistent)

Example)Beatrice has a monthly income of $100 and buys gasoline (Pg = $2) and a composite commodity Y (Py = $2). Say Beatrice consumes 20 gallons of gas and 30 units of Y each month (lets call that bundle A). In order to reduce our use of foreign oil, the government places a tax on gasoline resulting in a new price for gas of Pg = $4. But to eliminate the hardship of extra taxes, the government decides to give citizens like Beatrice $40 per month. They call this the Gas Tax and Gift Policy (GaTGiP).Will Beatrice be better or worse off after the GaTGiP, Tax and Gift policy? Verbally and using the above graph, explain how you know.Will the tax raise enough revenue to pay for the $40 gift? Explain.

Substitutes/ComplementsWhen PXQY(Complements),

True/False: Y could not possibly be an inferior good for you.True/False: X could not possibly be an inferior good for you.

Compensated Demand CurveCurve showing, for each price, what the quantity demanded would be if the consumer were income-compensated for all price changes (if there were no income effect.)Allows for isolation of substitution effectConfirms that compensated demand curve downward sloping

EXHIBIT 4.12Compensated and Uncompensated Demand Curve

PriceQdP1=$17P2=$31

Summing Individual Demands to Obtain Market Demand

ElasticityAnticipate changes in consumer buying habitsPrediction about direction of changeIf income increases or price falls, consumer buys moreNo predictions about magnitude of changeConsumption and expenditures change by how muchAn elasticity can be calculated for any relationships between two variablesthe price elasticity of demandthe income elasticity of demandthe cross-price elasticity.

Price ElasticityIf price of the good decreased by one dollar, by how many units would you increase your consumption of X?If price of the good decreased by 1%, by what percent would you increase your consumption of X?Slope = =

Price Elasticity of DemandArc Price elasticity:

Point Price elasticity:

The coefficient on Price of demand function. Ex) Q=22-2P:

More about Price ElasticityDemand highly elastic when price elasticity of demand has large absolute valueWhy one good is more elastic?Availability of substitutes

More about Price Elasticity

ElasticityDemand is consideredIf P increases, then total expenditure...e = 0perfectly inelasticQd completely insensitive to D in Pincreases0 < e < 1inelasticQd highly insensitive to D in Pincreasese = 1unit elastic% D in Qd exactly the same as the % D in Pdoes not change1 < e < elasticQd highly sensitive to D in Pdecreasese = perfectly elasticQd extremely sensitive to D in Pdecreases

REVENUE/EXPENDITURE AND ELASTICITYDemand Curve: Qd = 22-2P (or P = 11-.5Qd)

PriceQuantityPoint ElasticityTotal RevenueElastic?10220943686487856610605126041456316482183612020

Income Elasticity

Income elasticity =

The coefficient on INCOME of demand function. Ex) Q=1200-16*P+0.2*I :

ElasticityGoods are consideredeY < 0Inferior good0 eY 1Normal, NecessityeY > 1Normal, Luxury

Relationship between Income and Price Elasticity of DemandDeterminants of value of price elasticity of demand Size of substitution effectSize and direction of income effectLarger for goods that take up large fraction of income Larger for goods with high income elasticity of demandIncome effect depends on whether good normal or inferiorNormal: larger income effect means larger price elasticity of demandInferior: larger income effect means smaller price elasticity of demand

Cross Elasticity of DemandDemand for good X affected by change in price of some other good YUse cross elasticity of demand to measure size of effect Percent change in consumption of good X divided by the percent change in the price of good Y

Used to determine level and amount of monopoly power held by certain firms in antitrust cases

ElasticityGoods are consideredeQa,Pb > 0SubstituteseQa,Pb = 0Independent goodseQa,Pb < 0Complements

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