Chapter 5

Part A
5.1-5.3

Applying
Consumer Theory
 Topics

1. Deriving Demand Curves.

2. How Changes in Income Shift Demand

Curves.

3. Effects of a Price Change.

4. Deriving the demand function

mathematically.

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 Figure 5.1 Deriving
(a) Indifference Curves and Budget Constraints

Wine, (W), Gallons per year

12.0
an Individual’s
Demand Curve

Budget Line, L
e1
pwW + pbB = Y 2.8

L 1 (pb = $12) I1

0 26.7 Beer (b), Gallons per year

Y - Pb b (b) Demand Curve

W= Initial optimal bundle of
Pw
p b, $ per unit
Pw beer and wine

Initial Values
12.0 E1

Pb = price of beer = $12

Pw = price of wine = $35
Y = Income = $419.
Beer (b), Gallons per year
0 26.7

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 Figure 5.1 Deriving
(a) Indifference Curves and Budget Constraints

Wine, (W), Gallons per year

12.0
an Individual’s
Demand Curve

Budget Line, L
e2
4.3
e1
pwW + pbB = Y 2.8 I2

L 1 (p b = $12) I1 L 2 (p b = $6)

Y - Pb b 0 26.7 44.5 Beer (b), Gallons per year

W= Pw Pw (b) Demand Curve

p b , $ per unit
New Values
Pb = price of beer = $6
12.0 E1

Pw = price of wine = $35

Y = Income = $419.
E2
6.0

Price of beer goes down!

0 26.7 44.5 Beer (b), Gallons per year

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 Figure 5.1 Deriving (a) Indifference Curves and Budget Constraints

Wine, (W), Gallons per year

an Individual’s
12.0

Demand Curve

Budget Line, L 5.2

e3
Price-consumption curve

e2
4.3
e1 I3

pwW + pbB = Y 2.8 I2

L 1 (pb = $12) I1 L 2 (pb = $6) L 3 (p b = $4)

0 26.7 44.5 58.9 Beer (b), Gallons per year

Y - Pb b
W= Pw
(b) Demand Curve

Pw
New Values p b, $ per unit 12.0 E1

Pb = price of beer = $4
Pw = price of wine = $35 E2
6.0
Y = Income = $419. 4.0
E3
D1, Demand for Beer

Price of beer goes down again! 0 26.7 44.5 58.9 Beer (b), Gallons per year

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 Price-Consumption Curve

• A line through optimal bundles at each price

of one good (beer) when the price of the
other good (wine) and the budget are held
constant.

• The demand curve corresponds to the price-

consumption curve.

– Demand curve on a Price/Quantity graph

– Price consumption on a Quantity/Quantity graph

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 Effects of a Rise in Income

• Engel curve - the relationship between the

quantity demanded of a single good and
income, holding prices constant.

• Income-consumption curve shows how

consumption of both goods changes when
income changes, while prices are held
constant.

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 Figure 5.2 Effect of a

Wine, Gallons per year

Budget Increase on an
Individual’s Demand L1

Curve
2.8 e1
I1
0 26.7 Beer, Gallons per year

Price of beer, $ per unit

Budget Line, L 12
E1

Y Pb
W= P - b
w Pw
D1

Initial Values 0 26.7 Beer, Gallons per year

Pb = price of beer = $12

Y , Budget
Pw = price of wine = $35
$419
Y = Income = $419.
Y 1 = $419 E 1*

0 26.7 Beer, Gallons per year

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 Figure 5.2 Effect of a

Wine, Gallons per year

Budget Increase on an L2

Individual’s Demand L1

Curve
4.8 e2
2.8 e1
I2
I1
0 26.7 38.2 Beer, Gallons per year

Budget Line, L

Price of beer, $ per unit

Y - Pb
W= b E1 E2

PW
12

PW

Initial Values 0 26.7 38.2

D2
D1
Beer, Gallons per year

Pb = price of beer = $12

Y , Budget
PW = price of wine = $35
$628
Y = Income = $419.
Y 2 = $628 E 2*
Y 1 = $419 E 1*
Income goes up!
0 26.7 38.2 Beer, Gallons per year

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 Wine, Gallons per year
Figure 5.2 Effect of a
L3

Budget Increase on an L2

Individual’s Demand L1
Income-consumption curve

Curve 7.1
e2
e3

4.8
e1 I3
2.8 I2
I1
0 26.7 38.2 49.1 Beer, Gallons per year

Budget Line, L

Price of beer, $ per unit

Y - Pb E1 E2 E3

W= b
12

PW PW
D3
D2
D1
Initial Values 0 26.7 38.2 49.1 Beer, Gallons per year

Pb = price of beer = $12

Y , Budget
PW = price of wine = $35 Engel curve for beer

Y = Income = $837. Y 3 = $837

Y 2 = $628
E 3*

E 2*
Y 1 = $419 E 1*

Income goes up again! 0 26.7 38.2 49.1 Beer, Gallons per year

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 Consumer Theory and Income
Elasticities
• Formally,

– where Y stands for income.

• Example
– If a 1% increase in income results in a 3% increase
in quantity demanded, the income elasticity of
demand is x = 3%/1% = 3.

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 Consumer Theory and Income
Elasticities (cont.)

• Normal good - a commodity of which as

much or more is demanded as income rises.
– Positive income elasticity.
• Luxury goods are normal goods with an income
elasticity greater than 1.
• Jaguar is 4.5, BMW 4.4, Jetta is 2.1
• Necessity goods are normal goods with an
income elasticity between 0 and 1.
• Inferior good - a commodity of which less
is demanded as income rises.
– Negative income elasticity.

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 Figure 5.3 Income-Consumption
Curves and Income Elasticities
• As income rises
Housing, Squarefeet per year

Food inferior,
housing normal
the budget
constraint shifts
L2
IC C 1
to the right.
a
– The income
Food normal, elasticities
housing normal depend on where
IC C 2 on the new
L1 b budget constraint
the new optimal
consumption
e
bundle will be.
c
Food normal,
IC C 3 housing inferior
I

Food, Pounds per year

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 Figure 5.3 Income-Consumption
Curves and Income Elasticities
Food inferior,
housing normal The income elasticities
depend on where on the
Housing, Squarefeet per year

new budget constraint

the new optimal
L2
IC C 1 consumption bundle will
a be.

If the quantity of a
I2 good decreases with a
L1 rise in income this is
an inferior good.
e

I1

Food, Pounds per year

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 Figure 5.3 Income-Consumption
Curves and Income Elasticities
The income elasticities
Housing, Squarefeet per year

depend on where on the

new budget constraint
the new optimal
L2 consumption bundle will
be.

I2 If the quantity of a
good decreases with a
L1 rise in income this is
an inferior good.
e

c
Food normal,
IC C 3 housing inferior
I1

Food, Pounds per year

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 Figure 5.3 Income-Consumption
Curves and Income Elasticities
If the quantity of a
Housing, Squarefeet per year

good increases with

a rise in income this
is a normal good.
L2

Food normal,
housing normal

IC C 2
L1 b

e I2

Food normal,
housing inferior
I1

Food, Pounds per year

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 Figure 5.3 Income-Consumption
Curves and Income Elasticities
Shape of income-
Housing, Squarefeet per year

Food inferior, consumption curve for

housing normal
two goods tells us the
IC C 1 sign of their income
L2
elasticities.
a

Food normal,
housing normal The elasticities will tell
us how the good is
L1 b
IC C 2
viewed e.g. normal of
inferior.
e

c
Food normal,
IC C 3 housing inferior
I

Food, Pounds per year

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 A Good That Is (a) Indifference Curves and Budget Constraints

All other goods per year

Both Inferior Y3 L3

and Normal Y2 L
2
Income-consumption curve
e3

• When Gail was poor and her

income increased she Y1 L
1
I3

bought more hamburger.

e2

e1 I2

• But as she became wealthier I1

and her income rose she (b) Engel Curve

Hamburger peryear

bought less hamburger and

Y , Income
more steak. Y3 E3

Y2 E2
• Backward bending curves Engel curve

• Shape of ICC and Engle Y1

E1
curve indicate normal or
inferior
Hamburger peryear

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 Topics

1. Deriving Demand Curves.

2. How Changes in Income Shift Demand

Curves.

Effects
3. Effects of a Price
of a Price Change.
Change.

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 Effects of a Price Change

• A change in the price of a good has two

effects:

– Substitution Effect

– Income Effect

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 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

– For example: food and housing.

• Housing gets more expensive → relative price of
housing to food goes up → less housing more food
keeps you happy.

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 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 increases, the

substitution effect always leads to a decrease in
the quantity demanded of the good

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 Income and Substitution Effects

• Income Effect
– Consumers experience a decrease in real
purchasing power when the price of one good
rises

– Higher prices reduces opportunity set.

• Like reducing income.

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 Income and Substitution Effects

• Income Effect
– The income effect is the change in an item’s
consumption brought about by the decrease in
purchasing power, with the price of the item held
constant

– When a person’s income decreases, the quantity

demanded for the product may increase or
decrease

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 Figure 5.4 Substitution and
Income Effects with Normal
Goods Y = €30
Price track = €0.5
Price live = €1
Price track increases to €1

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 Income and Substitution Effects
with an Inferior Good

• If a good is inferior, the income effect and

the substitution effect move in opposite
directions.
• For most inferior goods, the income effect is
smaller than the substitution effect.
• If the income effect more than offsets the
substitution effect, we have a Giffen good,
for which a decrease in its price causes the
quantity demanded to fall.

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 Figure 5.6 Giffen Good
Basketball, Tickets per year

When the price of movie tickets

L2
decreases the budget constraint
rotates out…
L1 e2

I2

e1 allowing the consumer to

increase her utility.

I1
Total effect Movies, Tickets per year
Nevertheless, the total effect is negative. WHY?
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 Figure 5.6 Giffen Good

• Even though the substitution

Basketball, Ti ckets per year

L2 effect is positive….
– …the income effect is larger
L1 e2 and negative (since this is
an inferior good).

L* I2

e1

e*

I1
Total effect Substitution effect Movies, Tickets per year
Income effect

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 Deriving Demand
Mathematically

• Laura’s Cobb Douglas utility function is:

U=T0.4M0.6
• T: tracks of music, M: live music

• Budget constraint: Y = pmM+ptT

• What is her demand function for T and M?

– Demand is a function of price/s and income
– M=f(pm, pt, Y) and T=f(pm, pt, Y)

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 (a) Indifference Curves and Budget Constraints

Wine, (W), Gallons per year

12.0

Remember the Price-consumption curve

example of beer and 5.2
e2
e3

wine…….. 4.3

2.8
e1 I3
I2

L 1 (pb = $12) I1 L 2 (pb = $6) L 3 (p b = $4)

We mapped the 0 26.7 44.5 58.9 Beer (b), Gallons per year
optimal bundle given (b) Demand Curve
a change in the price

p b, $ per unit
of beer
12.0 E1

We could then derive

the demand curve 6.0
E2

for beer (Q v P) 4.0

E3
D1, Demand for Beer

0 26.7 44.5 58.9 Beer (b), Gallons per year

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 Use formula: MUm/MUt = pm/pt

• U=T0.4M0.6 Take derivatives to find MU:

• MUm = 0.6T0.4M-0.4
• MUt = 0.4T-0.6M0.6
• MUm / MUt = 1.5T/M = pm/pt
• Rearranging: 1.5ptT = pmM
• Sub into budget constraint: Y = pmM+ptT
• Y = 1.5ptT+ptT = 2.5ptT

Demand function for T

• T= Y/(2.5pt) = 0.4 Y/pt

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 Deriving Demand functions

• T= 0.4 Y/pt (Rearranging: ptT = 0.4Y)

• What is demand for M?
• From previous slide:
• 1.5ptT = pmM
• M = 1.5ptT/pm
• Substitute for ptT:
• M = 1.5(0.4Y)/pm = (0.6Y)/pm

M = 0.6Y/pm Demand function for M

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 Calculating Quantity Demanded

Demand functions for T and M:

• T= 0.4 Y/pt and M = 0.6Y/pm
For initial values: Y=30, pt =0.5, pm =1
T= (0.4)(30)/0.5 = 24
M = (0.6)(30)/1 = 18

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 Change in Quantity Demanded

Demand functions for T and M:

• T= 0.4 Y/pt and M = 0.6Y/pm
For new values: Y=30, pt =1, pm =1
T= (0.4)(30)/1 = 12
M = (0.6)(30)/1 = 18 Pt doubles

T falls by 12 units

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 More formally…slope of demand

Demand functions for T and M:

• T= 0.4Y/pt and M = 0.6Y/pm
• T= 0.4Ypt -1 and M = 0.6Ypm-1

Calculate 𝜕T/𝜕pt = -0.4Ypt -2 < 0

Demand curve for T slopes down
Calculate 𝜕M/𝜕pm = -0.6Ypm -2 < 0
Demand curve for M slopes down

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 Normal or Inferior Good?

Demand functions for T and M:

• T= 0.4Y/pt and M = 0.6Y/pm

Calculate 𝜕T/𝜕Y = 0.4/pt > 0

T is a normal good
Calculate 𝜕M/𝜕Y = 0.6/pm > 0
M is a normal good

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 Substitutes or Complements?

Demand functions for T and M:

• T= 0.4 Y/pt and M = (0.6Y)/pm

Calculate 𝜕T/𝜕pm = 0
M is neither a substitute or a complement of T
Calculate 𝜕M/𝜕pt = 0
T is neither a substitute or a complement of M

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 Chapter 5 Part A Summary

• Deriving Demand Curves.

• How Changes in Income Shift Demand

Curves.

• Effects of a Price Change.

• Deriving the demand function

mathematically.

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