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Chapter Five Overview

1. Individual Demand Curves

The Theory of Demand 2. Income and Substitution Effects &

the Slope of Demand

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Copyright (c)2014 John Wiley & Sons, Inc.

• Applications:
Week 3  The Work-Leisure Trade-off
 Consumer Surplus

3. Constructing Market Demand

1 Chapter Five 2

Chapter Five Overview Individual Demand Curves

The Effects of a Change in Price

The Price Consumption Curve of Good X:
• Optimal Choice
• Demand Curve
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Copyright (c)2014 John Wiley & Sons, Inc.

Is the set of optimal baskets for
every possible price of good x,
holding all other prices and
income constant.

3 5
Chapter Five Chapter Five

Price Consumption Curves Individual Demand Curve

Y (units) PX
The price consumption curve for good x
PY = $4 can be written as the quantity consumed Individual
I = $40 of good x for any price of x. This is the Demand Curve
individual’s demand curve for good x. For X
10
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Price Consumption Curve

•
• • PX = 4 •
PX = 1 PX = 2 • U increasing
PX = 2
PX = 1 •
PX = 4 X
0 X (units) XA XB XC
XA=2 XB=10 XC=16 20
Chapter Five 6 Chapter Five 7

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Individual Demand Curve Demand Curve for “X”

 The consumer is maximizing utility at every point along the Algebraically, we can solve for the individual’s
demand curve demand using the following equations:

 The marginal rate of substitution falls along the demand curve 1. pxx + pyy = I
as the price of x falls (if there was an interior solution). 2. MUx/px = MUy/py – at a tangency.

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Copyright (c)2014 John Wiley & Sons, Inc.

 As the price of x falls, it causes the consumer to move down (If this never holds, a corner point may be
and to the right along the demand curve as utility increases in substituted where x = 0 or y = 0)
that direction.

The demand curve is also the “willingness to pay” curve – and

willingness to pay for an additional unit of X falls as more X is
consumed. 8 9
Chapter Five Chapter Five

Demand Curve with an Interior Solution Change in Income & Demand

Suppose that U(x,y) = xy. MUx = y and

MUy = x. The prices of x and y are px
and py, respectively and income = I.
The income consumption curve of
good x is the set of optimal baskets
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Copyright (c)2014 John Wiley & Sons, Inc.

We Have: for every possible level of income.
1. pxx + pyy = I
2. x/py = y/px
We can graph the points on the
Substituting the second condition into the
budget constraint, we then have:
income consumption curve as
points on a shifting demand curve.
3. pxx + py(px/py)x = I or…x = I/2px

10 11
Chapter Five Chapter Five

Income Consumption Curve Engel Curves

The income consumption curve for

good x also can be written as the
quantity consumed of good x for any
income level. This is the individual’s
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Engel Curve for good x. When the

income consumption curve is
positively sloped, the slope of the
Engel Curve is positive.

Chapter Five 12 Chapter Five 13

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Engel Curves Definitions of Goods

I ($) • If the income consumption curve shows that the consumer
purchases more of good x as her income rises, good x is a normal
good.
Engel Curve
“X is a normal good”
92 • Equivalently, if the slope of the Engel curve is positive, the
good is a normal good.

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68
• If the income consumption curve shows that the consumer
purchases less of good x as her income rises, good x is an inferior
40
good.

• Equivalently, if the slope of the Engel curve is negative, the

0 10 18 24 X (units) good is an inferior good.
Chapter Five 14 Chapter Five 15

Definitions of Goods Impact of Change in the Price of a Good

Example: Backward Bending

Engel Curve – a good can be • Substitution Effect: Relative change in price
normal over some ranges and affects the amount of good that is bought as
inferior over others
consumer tries to achieve the same level of
utility
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• Income Effect: Consumer’s purchasing
power changes and affects the consumer in
a way similar to effect of a change in income

16 17
Chapter Five Chapter Five

The Substitution Effect Impact of Change in the Price of a Good

• As the price of x falls, all else constant, good x Definition: As the price of x falls, all else
becomes cheaper relative to good y. constant, purchasing power rises. As the price
of x rises, all else constant, purchasing power
•This change in relative prices alone causes the
falls.
consumer to adjust his/ her consumption basket.
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Copyright (c)2014 John Wiley & Sons, Inc.

• This effect is called the substitution effect. This is called the income effect of a change in
• The substitution effect always is negative. price.

• Usually, a move along a demand curve will be The income effect may be positive (normal
composed of both effects. good) or negative (inferior good).
Chapter Five 18 Chapter Five 19

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Impact of Change in the Price of a Good The Substitution and Income Effects

•If price of a good falls – consumer

Clothing
substitutes into the good to achieve the • Initial Basket

Y
same level of utility • Final Basket

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Copyright (c)2014 John Wiley & Sons, Inc.

• Decomposition
•When price falls – purchasing power Basket
increases the consumer can buy the same BLd
A C

amount and still have money left B U2

U1
BL1 BL2

XA X
XB XC
Chapter Five 20 Food 21

The Substitution and Income Effects The Substitution and Income Effects

• Initial Basket A
Px1
Slope of BL1  
Py
Clothing

• Final Basket C
Y

Px1
Slope of BL1
Py
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Copyright (c)2014 John Wiley & Sons, Inc.

Px 2
Slope of BL2 
Py

A C
• Decomposition
BLd P
B U2
Basket B Slope of BL 
P
1
x1

U1 P
Slope of BL2  x 2
BL1 BL2 Py
XA X P
22
XB XC
Food Slope of BL d 23 x 2
Chapter Five Py

The Substitution and Income Effects Giffen Goods

If a good is so inferior that the net effect of a price

decrease of good x, all else constant, is a decrease in
consumption of good x, good x is a Giffen good.

For Giffen goods, demand does not slope down.

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Copyright (c)2014 John Wiley & Sons, Inc.

When might an income effect be large enough to

offset the substitution effect? The good would have
to represent a very large proportion of the budget.

Chapter Five 24 Chapter Five 25

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Giffen Goods – Income and Substitution Effects Example – Income and Substitution Effects

Suppose U(x,y) = xy  MUx = y, MUy = x

Py = $1/unit and I = $72

Suppose that Px1 = $9/unit. What is the (initial) optimal

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Copyright (c)2014 John Wiley & Sons, Inc.

consumption basket?

Tangency Condition: MUx/MUy = Px/Py  y = 9x

Constraint: Pxx + Pyy = I  9x + y = 72

Solving: x = 4 and y = 36

Chapter Five 26 Chapter Five 27

Example – Income and Substitution Effects Example – Income and Substitution Effects

Find the decomposition basket B.

Suppose U(x,y) = XY  MUx = y, MUy = x 1. It must lie on the original indifference curve U1 along with
Py = $1/unit and I = $72 basket A  U1 = XY = 4(36) = 144.
2. It must lie at the point where the decomposition budget
Suppose that price of x falls and Px2 = $4/unit. What is the line is tangent to the indifference curve.
3. Price of X (PX) on the decomposition budget line is final
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Copyright (c)2014 John Wiley & Sons, Inc.

(final) optimal consumption basket?
price of $4.
Tangency Condition: MUx/MUy = Px/Py  y = 4x
Constraint: Pxx + Pyy = I  4x + y = 72 Tangency Condition: MUx/MUy = Px/Py  y = 4x
Combined with XY = 144  x = 6, y = 24
Solving: x = 9 and y = 36
Substitution Effect: 6 – 4 = 2 units of X
Income Effect: 9 – 6 = 3 units of X
28 29
Chapter Five Chapter Five

Consumer Surplus Consumer Surplus

• The individual’s demand curve can be seen as the Definition: The net economic benefit to the
individual’s willingness to pay curve. consumer due to a purchase (i.e. the willingness to
pay of the consumer net of the actual expenditure
• On the other hand, the individual must only on the good) is called consumer surplus.
actually pay the market price for (all) the units
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consumed.
The area under an ordinary demand curve and
•Consumer Surplus is the difference between what above the market price provides a measure of
the consumer is willing to pay and what the consumer surplus
consumer actually pays.

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Consumer Surplus Market Demand

G = .5(10-3)(28) = 98
The market demand function is the
H+I= 28 +2 = 30 horizontal sum of the individual (or segment)
CS2 = .5(10-2)(32) = 128
CSP = (10-P)(40-4P) demands.

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Copyright (c)2014 John Wiley & Sons, Inc.

In other words, market demand is obtained
by adding the quantities demanded by the
individuals (or segments) at each price and
plotting this total quantity for all possible
prices.

Chapter Five 32 Chapter Five 33

Market Demand Network Externalities

• If one consumer's demand for a good

P P P changes with the number of other
consumers who buy the good, there are
10
Q = 10 - P network externalities.
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Copyright (c)2014 John Wiley & Sons, Inc.

Q = 20 – 5P
4

Q Q Q
Segment 1 Segment 2 Market demand

34 35
Chapter Five

Network Externalities Network Externalities

D60
• Bandwagon effect: A positive network PX
externality that refers to the increase in D30 Bandwagon Effect:
each consumer’s demand for a good as • (increased quantity
demanded when more
more consumers buy the good consumers purchase)
•
A
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20

B C
10 • •
Pure Market Demand
Price
Effect
Bandwagon
Effect

36 60 37

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Network Externalities Network Externalities

PX
• Snob effect: A negative network
externality that refers to the decrease in Market Demand Snob Effect:
• (decreased quantity
each consumer’s demand as more demanded when more
consumers buy the good •
A consumers purchase)

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Copyright (c)2014 John Wiley & Sons, Inc.

C B
900 • • D1000

D1300
Snob Effect

Pure Price Effect X (units)

38 39

Labor-Leisure Trade-off Defining Labor Supply

• Divide the day into two parts: Work hours • Total Daily income:
and leisure (non work) hours. • w(24-L)
• Earns income during work hours and uses where w is the hourly wage rate
the income to pay for activities he enjoys
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L is the leisure hours
in his leisure time.
24 is the 24 hours in a day

40 41

Supply of Labor Labor Supply Curve

• An increase in wage rate reduces the • The labor supply curve slopes upward
amount of labor required to buy a unit of over the region where the substitution
the composite good effect associated with the wage increase
• This leads to both a Substitution effect and outweighs the income effect, but bends
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Copyright (c)2014 John Wiley & Sons, Inc.

Income effect. backward over the region where the

income effect outweighs the substitution
effect.

42 43

7
 Labor Supply Curve

44

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