Chapter 4

Demand and
Behavior
in Markets
 •2

The Problem of Consumer Choice

 Maximize utility
 Indifference curve tangent to budget line
 MRS = price ratio
 On budget line

 Quantity demanded of a good

 People seek to purchase at a given price
 •3

 Optimal consumption bundle

Good 2 (x 2)

B
20

e I3

I2 x1 + x2 = 20

F I1
B’
0 20 Good 1 (x 1)
 •4

Demand is homogenous
 Ifincome and all prices double, the quantity
demanded of all goods remains the same
 Reason: same budget constraint
Changes in Income
 When income only increases,
 Normal good: demand for goods increases
 Inferior good: demand decreases, e.g. used clothes,
bus tickets,..
 Show graphically
 •6

Superior and inferior goods

(a) (b)
Good 2 (x 2)

Good 2 (x 2)
0 Good 1 (x 1) 0 Good 1 (x 1)
 •7

Homothetic Preferences
 Homothetic preferences
 Indifference curves
 Do not “rotate” as consumer’s income increases
 Along any ray from the origin
 MRS – constant
 Increase in income
 Proportional increase in goods purchased
 All goods are superior
 No change in tastes
 •8

Good 2 (x 2)

D
60

Income expansion path

C
40
s
20 B r
e

B’ C’ D’
0 20 40 60 Good 1 (x 1)
 •9

Price-Consumption Paths
 Price-consumption path / curve
 Consumption changes
 One price changes
 All other prices – constant
 Consumer’s income – constant
 •10

Effects of Price changes on

budget
 Changing relative prices
 Optimal bundle
 Indifference
curve tangent to budget line
 MRS = Price ratio

 Good 1 – relatively less expensive

 Rotation of budget line – flatter
 Good 1 – relatively more expensive
 Rotation of budget line – steeper
 •11

Good 2 (x 2)

g
e
f

B” B’ B*
0 a b c Good 1 (x 1)

As the price of good 1 varies, the slope of the budget line changes leading to
different levels of consumption
 •12

Demand Curves
 Demand curve
 Relationship between
 Quantity demanded
 Price
 As the price varies
 Other things constant

 Image of the price-consumption path

 Generated: utility-maximizing behavior
 •13

 Demand curve for good1

Price

p1=2

p1=1

p1=1/2

0 a b c Good 1 (x 1)

The demand curve for good 1 associates the optimal quantity of good 1 with its
price, while holding income and other prices constant.
 •14

Demand and Utility Functions

 Nonconvex preferences
 Optimal consumption bundle
 At the corner of the feasible set
 Maximize utility
 Spend all income on only one good
 Demand curve
 If price > p*, quantity = 0
 If price = p*, quantity > 0
 As price decreases, quantity increases
 •15

 Non convex preferences and demand

(a) Price (b)
Good 2 (x 2)

X1=m/p1
B
p1*
h

p*
e

k
0 Good 1 (x 1) 0 g* Good 1 (x 1)

Non-convex preferences imply optimal Demand curve.

consumption bundles at the corners of Non-convex preferences imply jumps
the feasible set—either point h or point k. in the demand curve.
 •16

Decomposing the Effects of a Price

Change
 Substitution Effect: change in consumption caused
by a change in relative prices
 Income Effect: change in consumption as a result
of a change in the budget set
 •17

Substitution Effect
 Change in demand due to substitution
 One good (decreasing price)
 For another good (constant price)

 The substitution effect from the decline in price

always increases demand
 •18

Income Effect
 Income effect
 Decrease in price is equivalent to an increase in real
income
 The income effect from the decline in price will
cause demand to
 Increaseif the good is normal
 Decrease if the good is inferior
 •19

Good 2 (x 2) (a) Price (b)

p’
D
e
f p”
g
I2
I1 p”
p’

0 B’ D’ B” Good 1 (x 1)
Substitution effect Income effect 0 e f Good 1 (x 1)
The income effect of the price change is Downward-sloping demand curve
measured by the parallel shift of the budget
line from DD’ to BB”. The substitution effect
is measured by movement around the
indifference curve from e to g.
 •20

Inferior Goods: Income and substitution effects work on

opposite directions
Good 2 (x 2)
How does the demand
B curve for good 1 look
f like?

D e I2

Substitution
g
effect Income effect
I1

0 B’ D’ B” Good 1 (x 1)
The substitution effect of a decline in the price of good 1 causes an increase in demand
for the good, the move from e to g. Because good 1 is an inferior good, this is partly
offset by the income effect, a decrease in demand for the good from g to f .
 •21

Giffen Goods and Upward-Sloping

Demand Curves

 Giffen good
 Upper sloping demand curve
 Inferior good
 A price decrease
 Substitution effect
 Increase demand
 Income effect
 Decrease demand
 Dominant effect: income effect
 •22

 Giffen good

Good 2 (x 2)

B
f
I2
Income effect
Substitution
D e effect

g
I1
0 B’ D’ B” Good 1 (x 1)

The decline in the price of good 1 causes a decline in the demand for that
good because the substitution effect (the move from e to g) is more than offset
by the income effect (the move from g to f ).
 •23

Identifying normal and Giffen

goods

Type of good Substitution effect Income effect

Normal Opposite to price change The good is either superior or inferior
downward but with an income effect that is less
sloping D powerful than the substitution effect.

Giffen Upward Opposite to price change The good is inferior.

sloping D The income effect is more powerful
than the substitution effect.
Good 2 (x 2)

20

g
e
f

8 10 15 18 20 40 Good 1 (x )
0 1