SE-IE Law of Demand Effect of a

SE-IE: Law of Demand

Effect of a Price Change Clothing (units per month) Assume: • I = $20 • PC = $2 • PF = $2, $1, $. 50 10 A 6 U 1 5 D B U 3 4 Three separate indifference curves are tangent to each budget line. U 2 4 Chapter 4 12 20 Food (units per month) Slide 2

Effect of a Price Change The price-consumption curve traces out the utility maximizing market basket for the various prices for food. Clothing (units per month) A 6 Price-Consumption Curve U 1 5 D B U 3 4 U 2 4 Chapter 4 12 20 Food (units per month) Slide 3

Effect of a Price Change Price of Food Individual Demand relates the quantity of a good that a consumer will buy to the price of that good. E $2. 00 G $1. 00 Demand Curve $. 50 H 4 Chapter 4 12 20 Food (units per month) Slide 4

Individual Demand The Individual Demand Curve n Two Important Properties of Demand Curves 1) The level of utility that can be attained changes as we move along the curve. Chapter 4 Slide 5

Individual Demand The Individual Demand Curve n Two Important Properties of Demand Curves 2) 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. Chapter 4 Slide 6

Effect of a Price Change Price of Food When the price falls: Pf/Pc & MRS also fall E $2. 00 • E: Pf/Pc = 2/2 = 1 = MRS • G: Pf/Pc = 1/2 =. 5 = MRS • H: Pf/Pc =. 5/2 =. 25 = MRS G $1. 00 Demand Curve $. 50 H 4 Chapter 4 12 20 Food (units per month) Slide 7

Individual Demand n Income Changes l Chapter 4 Using the figures developed in the previous chapter, the impact of a change in the income can be illustrated using indifference curves. Slide 8

Effects of Income Changes Clothing (units per month) Assume: Pf = $1 Pc = $2 I = $10, $20, $30 7 D 5 U 2 B 3 U 1 A 4 Chapter 4 10 16 Income-Consumption Curve U 3 An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. Food (units per month) Slide 9

Effects of Income Changes Price of food An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right. E $1. 00 G H D 3 D 2 D 1 4 Chapter 4 10 16 Food (units per month) Slide 10

Individual Demand n Income Changes l The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level. Chapter 4 Slide 11

Individual Demand n Income Changes l An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve. l Simultaneously, the increase in income shifts the demand curve to the right. Chapter 4 Slide 12

Individual Demand Normal Good vs. Inferior Good n Income Changes l Chapter 4 When the income-consumption curve has a positive slope: u The quantity demanded increases with income. u The income elasticity of demand is positive. u The good is a normal good. Slide 13

Individual Demand Normal Good vs. Inferior Good n Income Changes l Chapter 4 When the income-consumption curve has a negative slope: u The quantity demanded decreases with income. u The income elasticity of demand is negative. u The good is an inferior good. Slide 14

An Inferior Good Steak 15 (units per month) Income-Consumption Curve C 10 Both hamburger and steak behave as a normal good, between A and B. . . U 3 B 5 U 2 A U 1 5 Chapter 4 10 20 …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. Hamburger 30 (units per month) Slide 15

Individual Demand n Engel Curves l Engel curves relate the quantity of good consumed to income. l If the good is a normal good, the Engel curve is upward sloping. l If the good is an inferior good, the Engel curve is downward sloping. Chapter 4 Slide 16

Engel Curves Income ($ per month) 30 Engel curves slope upward for normal goods. 20 10 0 Chapter 4 4 8 12 16 Food (units per month) Slide 17

Engel Curves Income ($ per month) 30 Inferior Engel curves slope backward bending for inferior goods. 20 Normal 10 0 Chapter 4 4 8 12 16 Food (units per month) Slide 18

Individual Demand Substitutes and Complements 1) Two goods are considered substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other. u Chapter 4 e. g. movie tickets and video rentals Slide 19

Individual Demand Substitutes and Complements 2) Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other. u Chapter 4 e. g. gasoline and motor oil Slide 20

Individual Demand Substitutes and Complements 3) Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other Chapter 4 Slide 21

Individual Demand n Substitutes and Complements l l n 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! Chapter 4 Slide 22

Income and Substitution Effects n A fall in the price of a good has two effects: Substitution & Income l Substitution Effect u Chapter 4 Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive. Slide 23

Income and Substitution Effects n A fall in the price of a good has two effects: Substitution & Income l Income Effect u. Consumers experience an increase in real purchasing power when the price of one good falls. Chapter 4 Slide 24

Income and Substitution Effects n Substitution Effect l 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. l When the price of an item declines, the substitution effect always leads to an increase in the quantity of the item demanded. Chapter 4 Slide 25

Income and Substitution Effects n Income Effect l 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. l When a person’s income increases, the quantity demanded for the product may increase or decrease. Chapter 4 Slide 26

Income and Substitution Effects n Income Effect l Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect. Chapter 4 Slide 27

Income and Substitution Effects: Normal Good Clothing (units per month) R When the price of food falls, consumption increases by F 1 F 2 as the consumer moves from A to B. The substitution effect, F 1 E, (from point A to D), changes the A relative prices but keeps real income (satisfaction) constant. C 1 D C 2 B U 2 Substitution Effect O Chapter 4 F 1 Total Effect The income effect, EF 2, ( from D to B) keeps relative prices constant but increases purchasing power. U 1 E S F 2 T Income Effect Food (units per month) Slide 28

Income and Substitution Effects: Inferior Good Clothing (units per month) R Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. A B U 2 D Substitution Effect O Chapter 4 F 1 U 1 E Total Effect S F 2 T Food (units per month) Income Effect Slide 29

Income and Substitution Effects n A Special Case--The Giffen Good l The income effect may theoretically be large enough to cause the demand curve for a good to slope upward. l This rarely occurs and is of little practical interest. Chapter 4 Slide 30