Microeconomics: Theory and Applications

with Calculus Cobb -

optimal
Fifth Edition, Global Edition
F. of .
→ solve optimal bundle

Chapter 4

Demand

I have enough money to last me the

rest of my life, unless I buy something.
Jackie Mason

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Chapter 4 Outline
Challenge: Paying Employees to Relocate
4.1 Deriving Demand Curves
4.2 Effects of an Increase in Income
4.3 Effects of a Price Increase
4.4 Cost-of-Living Adjustment
4.5 Revealed Preference
Challenge Solution

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Challenge: Paying Employees
to Relocate
• Background:
– International firms are increasingly relocating workers
throughout their home countries and internationally.
– Firms must decide how much compensation to offer
workers to move.

• Question:
– Do firms’ standard compensation packages
overcompensate workers by paying them more than
necessary to include them to move to a new location?
under ?
or
compensate

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4.1 Deriving Demand Curves (1 of 2)
• If we hold people’s tastes, their incomes, and the prices of
other goods constant, a change in the price of a good will
cause a movement along the demand curve.
• We saw this in Chapter 2:
é-D(Pja,B.
Demand

F- f- ( Qd / holding other

variable constant)

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4.1 Deriving Demand Curves (2 of 2)
• In Chapter 3, we used calculus to maximize consumer
utility subject to a budget constraint.
– This amounts to solving for the consumer’s system of
demand functions for the goods.
• Example: q1 = pizza and q2 = burritos |Good#
– Demand functions express these quantities in terms of
the prices of both goods and income:
q1 = Z ( p1, p2 ,Y ) In
general
q2 = B( p1, p2 ,Y )
– Given a specific utility function, we can find closed-form
solutions for the demand functions.
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F. oc q ? too ,
=

74¥ ) -
- -

① Highly nonlinear

a: too .

=×(¥ / ,
- . -

Y= P G, ,
1- Page - - -
③

=
No closed form solution .

*
* *
G. , g. ,
✗ must satisfy 3 equations at same time
 4.1 Demand Functions for Five Utility
Functions
closed form solution

I
-

{ g. =

Rich sufficiently
large
=
IPIR income low I

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 Budget share for
4.1 Example: Deriving Demand 14
Good 1

Curves (2 of 2) at

* E > =
( 1- a) Y
• Cobb-Douglas utility function: EYE > =aYt( 1- a) Y=Y

U (q1, q2 ) = q1aq21-a

• Budget constraint:
Y = p1q1 + p2q2
• In Chapter 3, we learned that the demand functions that
result from this constrained optimization problem are:
"
"

Y Y special case

Pi=¥ q1 = a q2 = (1 - a )
p1 p2
• With Cobb-Douglas, quantity demanded of each good is a
function of only the good’s own-price and income.
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4.1 Deriving Demand Curves
• Panel (a) below shows the demand curve for q1, which we
plot by holding Y fixed and varying p1.

Good 1

F- =
÷É¥÷ •*ÉÉ=¥

°µrs=ÑRT~
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4.1 Deriving Demand Curves Graphically
• Allowing the price of the
good on the horizontal
flat → more
axis of (a) to fall, the p
Slope beer

budget constraint rotates

out and shows how the
optimal quantity of the -

horizontal-axis good .

purchased increases.
– This traces out points
along the demand
curve in (b).

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 "
"p
/
=

P PCC

0oz ifcq )
.
I
80

og

@2

@
,

Cobb -

Douglas :

a- qaq
' -
a P, t ; PT
,

g. T
=a¥
Rt
a.
g-

7¥
"
g. =
4.2 Effects of an Increase in Income (1 of 2)

=
• An increase in an individual’s income, holding tastes and
prices constant, causes a shift of the demand curve.
– An increase in income causes an increase in demand
(e.g. a parallel shift away from the origin) if the good is
a normal good and a decrease in demand (e.g.
parallel shift toward the origin) if the good is inferior.
• A change in income prompts the consumer to choose a
new optimal bundle.
• The result of the change in income and the new utility
maximizing choice can be depicted three different ways.

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4.2 Effects of an Increase in Income (2 of 2)
• The result of the change in income and the new utility
maximizing choice can be depicted three different ways.

,-
1. Income-consumption curve: using the consumer
utility maximization diagram, traces out a line
connecting optimal consumption bundles.
2. Shifts in demand curve: using demand diagram,
show how quantity demanded increases as the price
of the good stays constant.
3. Engle curve: with income on the vertical axis, show
the positive relationship between income and quantity
demanded. Y
Gd =
ELY )
> Engle
q Copyright © 2022 Pearson Education Ltd
,
4.2 Effects of a
I

Budget Increase (1 of 2)
• Allowing income to E. E. Yi
- '

increase, the budget Parallel

f
constraint shifts out and
← Y=Y
shows how the optimal
,

f-Ya
-
←

quantity of the horizontal- E

axis good purchased
increases.
– This traces out points
along the Engel curve
a

qi qui
-

u
-
-

in (b). T

☒ ☐
C)
q .

Y=÷
=¥,

_ ☐
•☐

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PB Dak)

'
p
)
- - - - -
- -

DIY
. -
.

GB

tp > P' QEW > a:( E)

tP< P' qrilk-qis.lk ) *

contradiction

Y= ( Ia ) As

y 'T
qP Engle

y*É""
a >0
+ ve slope
p >
,
o

Beer normal

G- B If at ? Engle curve

Become f- lather

p 'T steeper Y=y* q.tl

 P*=pHeofpe
of
4.2 Effects of a p price coke
=

Budget Increase (2 of 2)
• Allowing income to
increase, the budget
constraint shifts out and Mrs

f- ÷
=

shows how the optimal

.

quantity of the horizontal- MRT

:*
axis good purchased
0
=

increases. Ay ÑRS and MRT

– This traces out points
along the Engel curve
in (b). & y
Engle

¥0
=

y =p q

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 Threshold
u=q+q*

1- p*
Engle curve

i pp

If p > p* q ☐ q* =

,I

¥9m
p > *
-

.
'

Price of coke > Price pepsi

n
q

-
Won't buy
'

<
.
coke
4.2 Consumer Theory and Income
Elasticities
¥
I ¥3'¥T
• Recall the formula for income elasticity of demand from
Chapter 2:
percentage change in quantity demanded DQ / Q ¶Q Y
x= = =
percentage change in income DY / Y ¶Y Q
• Normal goods, those goods that we buy more of when our
income increases, have a positive income elasticity.
– Luxury goods are normal goods with an income elasticity
greater than 1.
– Necessity goods are normal goods with an income
elasticity between 0 and 1.
• Inferior goods, those goods that we buy less of when our
income increases, have a negative income elasticity.

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 4.2 Income-Consumption Curve and
Income Elasticities (1 of 2)
• The shape of the income-consumption curve for two goods
tells us the sign of their income elasticities.

cloth
Food →inferior Food cloth

;
,

cloth → Normal Normal

II I

- -
•E - -
-
-

c.
-
- -

' Food → Normal

Impossible
± i #
Inferior → cloth
i
Food
Fo

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4.2 Income-Consumption Curve and
Income Elasticities (2 of 2)
• The shape of the income-
consumption and Engle
curves can change in
ways that indicate goods
can be both normal and
inferior, depending on an
individual’s income level.

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 GD 141T¥ -
constant :P . .lt
4.3 Effects of a Price Increase
• Holding tastes, other prices, and income constant, an
increase in the price of a good has two effects on an
individual’s demand:
1. Substitution effect: the change in quantity demanded
when the good’s price increases, holding other prices
and consumer utility constant.
2. Income effect: the change in quantity demanded when
income changes, holding prices constant.

• When the price of a good increases, the total change in

quantity demanded is the sum of the substitution and
income effects.
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 """y
1¥
ñ=ñ
e. → e* . Pi ☒

j(¥)
Qidt
.

pi
{
¥}
Q :b
real income . * ☒
:-<☐ curve :S * e* =p?
F. •
-2° I

4.3 Income and Substitution Effects ¥:< ¥ .

• The direction of the substitution effect is always negative.

– When price increases, individuals consume less of it
because they are substituting away from the now more
expensive good.
• The direction of the income effect depends upon whether
the good is normal or inferior; it depends upon the income
-
elasticity.
– When price increases and the good is normal, the
=
income effect is negative.
– When price increases and the good is inferior, the
income effect is positive. usually
IS .tl > II. El
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RT { SE : -
f
T E : -4 Satisfy law
I. E : 1-4
.

of demand

SE -8
{
=

TE : 2
IE -
-

to

P T
,
Did T Giffen Good ¥-55

① inferior good
Necessary IE need
'
positive
{②
' '

: -

IIEI > 1 SEI

4.3 Income and Substitution Effects
with a Normal Good e
'

µ -24
AM ' -_ 12
µz=,z
• Beginning from budget Y I
{
,

'

← Pm
constraint L , an
Live music 8
1 # keep
.

② FÉ 41¥13 .C tangent I
Pm
2 -
to

increase in the price of

music tracks rotates PmT pm
-

budget constraint into

L.
2
F
pi % ,
00

– The total effect of this price change, a decrease in

quantity of 12 tracks per quarter, can be
decomposed into income and=
-
substitution effects.

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 ☒
L* :
Imaginary B. C
?
,

(
Csmpansek consumer some

e* income to ache're :-(

•

:•
'

e- r e
•,• '
[
2 I
I T - ,

I
I. ,
L ,

12 24

"

e. → et : Sub effect "

>
Parallel { ¥1
:{ pPd;

e* → ez :-<name effect .
 e. → et SE e → e. Income effect
,

4.3 Income Effect with Perfect

Complements ① L ,
→ ,
e ,
→ ez ( Total effect)

③ Shift parallel that touch I

• Beginning from budget
,

constraint L1, an
increase in the price
of pie rotates budget
constraint into
L2 .
– The total effect of this price
÷
change with perfect
complements equals the
income effect.
t
– The case of perfect
complements has no
substitution effect.
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4.3 Income and Substitution Effects Prd 1. → :

with an Inferior (and Giffen) Good e* RT e, →

→ Lt
:

:
.
Allt

• Beginning from budget

constraint L1, an
decrease in the price
of rice rotates budget
constraint into
L2 .
e- → il 'M )
A is normal T
Rd
'

.
'

inferior ③ ①

– The total effect of this price change, a decrease in quantity of

rise, can be decomposed into income and substitution effects, in
which the negative income effect (rice is an inferior good)
outweighs the substitution effect

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it

•
e*
i.

! I .UA
:
i
1
1

00
'
U' < no
;•\>
i DI Hicks)
i.← q*
÷
U°
←
 ÷
4.3 Compensated Demand Curve (1 of 3)
• The demand curves shown thus far have all been
uncompensated, or Marshallian, demand curves.
– Consumer utility is allowed to vary with the price of the good.
– In the figure from the previous slide, utility fell when the
price of music tracks rose.
• Alternatively, a compensated, or Hicksian, demand curve
shows how quantity demanded changes when price increases,
holding utility constant.
– Only the pure substitution effect of the price change is
represented in this case.
– An individual must be compensated with extra income as
the price rises in order to hold utility constant.
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 **
4.3 Compensated Demand Curve (2 of 3)
• In calculating
compensated demand
curve for music tracks,
vary the price of music
tracks, compensate
income to hold utility
constant.
24 → 12 ( Un compensate
A)
• Determine the quantity i 24 -515.8 (
compensate
1)
demanded
For normal
same
/
good
f) ref point
:

H D is
.
steeper than M.D

For inferior good :

Hicks: an
M.D is steeper than H D
.

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3.4 Minimizing Expenditure BC
Max US -1. .

• Utility maximization has a dual problem in which the

I
-
consumer seeks the combination of goods that achieves a
particular level of utility for the least expenditure.
*

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= U*= 200
qE c. -
- -
÷

O
;

v
i. -

*
G. *
E- =P G. *
, + Pz Got

¥
3.4 Expenditure Minimization with
Calculus
• Minimize expenditure, E, subject to the constraint of
holding utility constant:
min E = p1q1 + p2q2
q1, q2

s.t. U = U (q1, q2 )
g.
In
• The solution of this problem, the expenditure function,
shows the minimum expenditure necessary to achieve a
specified utility level for a given set of prices:

-
(
E = E p1, p2 ,U )
P Pz Ñ
B. Ñ ) tpzqzlR.pz.lt ) parameter
'
are
E- PIG , (P , ,
- -

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4.3 Compensated Demand Curve (3 of 3)
• Deriving the compensated, or Hicksian, demand curve is straight-
forward with the expenditure function:
– E is the smallest expenditure that allows the consumer to achieve a
given level of utility based on given market prices:
E = E ( p1, p2 ,U )
– Differentiating with respect to the price of the first good yields the
compensated demand function for the first good:
¶E get HicksIan Demand Curve
= H ( p1, p2 ,U ) = q1
¶p1
▪ A $1 increase in p1 on each of the q1 units purchased
requires the consumer increases spending by $q1 to keep
utility constant. How much ET
-

▪ This result is called Shephard’s lemma. if P T

, by $ I
-

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 Book solve problem 3.8

u=q9qI
"

E LP , , Pa ,Ñ )?

-5
,Pz,Ñ)=2U ( P B)
°

E =
( P , . .

's 0.5
=
2Ñ ( P ,
)° (B)

3¥
" 5

Help ,Pz,Ñ ) ZÑ ,j
"

G. =
,
= = 10.5 ) ( p (p .
)
"
= ñ
1¥ )
p "5=(ñ
P, '

,
pis ¥)
( a- Ps)
'

p ,
=
£,

HD

Gi
 pp ai't

lawof-Demandi.EC#E=%A1nzD
4.3 Slutsky Equation %AinP

• We graphically decomposed the total effect of a price change on

quantity demanded into income and substitution effects.
• Deriving this same relationship mathematically utilizes elasticities
and is called the Slutsky equation. [-10.5/127]
,
total effect = substitution effect + income effect
-

t
-3 -2 ( tire) normal
e = e* + ( -qx ) 1- ve) inferior

– e is elasticity of uncompensated demand and the total effect

– e * is elasticity of compensated demand and the substitution
effect
– q is the share of the budget spent on the good 2. =
,0z=¥
– x is the income elasticity
– qx is the income effect
Copyright © 2022 Pearson Education Ltd
 E =
E* + IS

law of Demand : PT 2dL : Eco

Giffen Good :

① 8<0 inferior good

1031
'
② > IE l

/ effect / > Hefted

income

hard to find Giffen Good

why it is .

For most good ,

0 is small
 inflation rate
cPI g =/ 00
'
= 20% { cpzzsz ,
= 'M

4.4 Cost-of-Living Adjustment

• Consumer Price Index (CPI): measure of the cost of a
standard bundle of goods (market basket) to compare
prices over time.

2<aao<s[
– Example: In 2012 dollars, what is the cost of a real Pb
-12=42
McDonald’s hamburger in 1955?

÷÷
CPI for 2018 252.1
inflation
{ CPI for 1940
´ price of a burger =
14.0
´ 15¢ » $2.70.
13
""
-_
$3

• Knowledge of substitution and income effects allows us to

analyze how accurately the government measures inflation.
• Consumer theory can be used to show that the cost-of-
living measure used by governments overstates inflation.
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4.4 Cost-of-Living Adjustment Constant =
C. ,
F,

(COLA) (1 of 2) I F.) C. .

the same bundle

'

.
'

Es ) E , .
'

.
Y .
> Y ,

• CPI in first year is the cost of buying the market basket of

food (F) and clothing (C) that was actually purchased that
year: E E. E ,
=
c t , e

Y1 = pC1C1 + pF1 F1
• CPI in the second year is the cost of buying the first year’s
bundle in the second year: EE EE PE > P ;
+

Y2 = pC2C1 + pF2F1 P? > PÉ

• The rate of inflation determines how much additional income

it took to buy the first year’s bundle in the second year:
Y2 pC2C1 + pF2F1
☒; = 1
Y1 pCC1 + pF1 F1
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4.4 Cost-of-Living Adjustment
(COLA) (2 of 2) GLA Y*True

• If a person’s income
increases automatically
with the CPI, he can afford
to buy the first year’s
:÷:÷
better then set compensated hen B. C
bundle in the second year, o

I
but chooses not to.
– Better off in the second
year because the CPI-
based COLA
overcompensates in the
sense that utility
increases.

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 Y, .PE .PE
C
1¥ > PE
{ PE > PE

÷
:÷ 1¥ >

y%• *

B.ctha-passc.N.iq
① New B.
csteeper
PI
-•

② same bundle ( E. C.)

compensated New B.C New

(
same bundle

'

÷÷
i

i.
F
'
I
F
PÉ
Challenge Solution
• Relocate from Seattle to London y
>
¥÷
L
• Budget line in Seattle is Ls
and buys s. Utility is I 1. ☐
• Housing is relatively more
expensive in London. ☐
• If worker is compensated
when moving to afford s in
London, budget line is LL .
Worker consumes l and utility is I 2 .

• Firm should compensate L*. Worker consumes l* and utility is

I 1.

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