Chapter 4: Individual and Market Demand Lectures 12-13 Lecture Notes

Chapter 4 Individual and Market Demand Lectures: 12-13 Individual Demand Price Changes  Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves  For each price change, we can...

Chapter 4 Individual and Market Demand Lectures: 12-13 Individual Demand Price Changes  Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves  For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves  Effect of a Price Change Clothing Assume: I = $20 10 PC = $2 PF = $2, $1, $0.50 6 A Each price leads U1 D to different 5 B amounts of food 4 U3 purchased U2 Food (units per month) 4 12 20  Effect of a Price Change Clothing The Price- 10 Consumption Curve traces out the utility maximizing 6 A market basket U1 D for each price 5 B of food 4 U3 U2 Food (units per month) 4 12 20 Substitutes & Complements If the price consumption curve is downward-sloping, the two goods are considered substitutes If the price consumption curve is upward-sloping, the two goods are considered complements They could be both Effect of a Price Change  By changing prices and Demand Schedule showing what the consumer will P Q purchase, we can create a demand $2.00 4 schedule and demand curve for $1.00 12 the individual  From the previous $0.50 20 example:  Effect of a Price Change Price of Food E Individual Demand relates $2.00 the quantity of a good that a consumer will buy to the price of that good. G $1.00 Demand Curve $.50 H Food (units 4 12 20 per month) Demand Curves – Important Properties  The level of utility that can be attained changes as we move along the curve  At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing  MRS falls as we move down along the demand curve.  Effect of a Price Change Price of Food E When the price falls, $2.00 Pf /Pc & MRS also fall E: Pf /Pc = 2/2 = 1 = MRS G G: Pf /Pc = 1/2 =.5 $1.00 = MRS H:Pf /Pc =.5/2 $.50 =.25 = MRS H Demand Curve Food (units 4 12 20 per month) Individual Demand Income Changes Using the figures developed in the previous chapter, the impact of a change in the income can be illustrated using indifference curves Changing income, with prices fixed, causes consumers to change their market baskets  Effects of Income Changes Clothing (units per Assume: Pf = $1, Pc = $2 month) I = $10, $20, $30 An increase in income, with the prices fixed, causes consumers to alter their choice of 7 D market basket. U3 5 U2 B 3 A U1 Food (units 4 per month) 10 16 Individual Demand Income Changes The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level Individual Demand Income Changes  An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve  Simultaneously, the increase in income shifts the demand curve to the right  Effects of Income Changes Clothing (units per The Income Consumption month) Curve traces out the utility maximizing market basket for each income level Income Consumption 7 D Curve U3 5 U2 B 3 A U1 Food (units 4 per month) 10 16 Effects of Income Changes Price An increase in income, of from $10 to $20 to $30, food with the prices fixed, shifts the consumer’s demand curve to the right as well. E G H $1.00 D3 D2 D1 Food (units 4 10 16 per month) Individual Demand Income Changes When the income-consumption curve has a positive slope: The quantity demanded increases with income The income elasticity of demand is positive The good is a normal good Individual Demand Income Changes When the income-consumption curve has a negative slope: The quantity demanded decreases with income The income elasticity of demand is negative The good is an inferior good  An Inferior Good Steak Both hamburger (units per Income-Consumption and steak behave month) Curve as a normal good, C between A and B... 10 U3 …but hamburger becomes an inferior good when the income B consumption curve 5 bends backward between B and C. U2 A U1 Hamburger 30 (units per month) 5 10 20 Individual Demand Engel Curves  Engel curves relate the quantity of good consumed to income  If the good is a normal good, the Engel curve is upward sloping  If the good is an inferior good, the Engel curve is downward sloping  Engel Curves Income 30 ($ per month) Engel curves slope 20 upward for normal goods. 10 Food (units 4 8 12 16 per month)  Engel Curves Income 30 ($ per month) Inferior Engel curves are 20 backward bending for inferior goods. Normal 10 Food (units 4 8 12 16 per month) Income and Substitution Effects A change in the price of a good has two effects: Substitution Effect Income Effect Income and Substitution Effects Substitution Effect Relative price of a good changes when price changes Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive Income and Substitution Effects Income Effect Consumers experience an increase in real purchasing power when the price of one good falls Income and Substitution Effects Substitution Effect The substitution effect is the change in an item’s consumption associated with a change in the price of the item, with the level of utility held constant When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good Income and Substitution Effects Income Effect The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant When a person’s income increases, the quantity demanded for the product may increase or decrease Income and Substitution Effects Income Effect Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect  Income and Substitution Effects: Normal Good Clothing When the price of food (units per falls, consumption month)R increases by F1F2 as the consumer moves from A to B. The substitution effect, F1E, (from point A to D), changes the C1 A relative prices but keeps real income (satisfaction) constant. The income effect, EF2, (from D to B) keeps relative D B prices constant but C2 increases purchasing power. Substitution U2 Effect U1 Food (units O F1 Total Effect E S F2 T per month) Income Effect  Income and Substitution Effects: Inferior Good Clothing (units per Since food is an month) R inferior good, the income effect is negative. However, the substitution effect A is larger than the income effect. B U2 D Substitution Effect U1 Food (units O F1 E S F2 T per month) Total Effect Income Effect