steven landsburg, university of rochester chapter 4 consumers in the marketplace copyright ©2005 by...

Steven Landsburg,

University of Rochester

Chapter 4Consumers in the Marketplace

Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Applications, 6th edition 2

Introduction

• Consumption choices change as a function of price and income

• Prices go up, quantity demanded goes down

• Prices go up, budget line pivots and consumers choose a new consumption point

• Reconcile these two stories


Changes in Income

• Use composite good convention

• Changes in income and budget line– Result in a parallel shift of the budget line

• Changes in income and optimum point– If good normal, as income rises, consumption

increases– If good inferior, as income rises, consumption

decreases


EXHIBIT 4.3 Normal and Inferior Goods


Engel Curve

• Curve showing for fixed prices, relationship between income and quantity of good consumed

• Need to know prices of goods consuming and indifference curves– Can generate coordinates of points on Engel curve

• Shape of Engel curve– Upward-sloping if good X is normal

• If consumer income rises, consumes more of good X

– Downward-sloping if good X is inferior• If consumer income rises, consumes less of good X


EXHIBIT 4.4 Constructing the Engel Curve


Changes in Price

• Income and price of good Y remain fixed• Change in price of X has no effect on y-intercept

of budget line– Budget line pivots around y-intercept– Rise in price of X causes budget line to pivot inward– fall in price of X causes budget line to pivot outward

• Changes in optimum point– Located anywhere along new budget line


Giffen Goods

• If price of X increases, quantity demanded decreases– Follows law of demand– Goods called non-Giffen goods

• If price of X increases, quantity demanded increases– Violates law of demand– Goods called Giffen goods

• Giffen goods rare or nonexistent– Theory of indifference curves indicates exceptions to

law of demand


EXHIBIT 4.7 Non-Giffen Goods and Giffen Goods


The Demand Curve

• Engel curve relationship to demand curve– Engel curve: relationship between income and

consumption• Plots income on horizontal axis and consumption

on the vertical axis

– Demand curve: relationship between price and consumption

• Plots price on the vertical axis and consumption on the horizontal axis


Constructing the Demand Curve

• Derived from indifference curves– Find price of X– Draw budget line given income and prices– Find tangency between budget line and

indifference curve– Read off quantity of X– Plot point on demand curve relating price to

quantity– Repeat the process for additional points on

the demand curve


EXHIBIT 4.10 Income and Substitution Effects


Shape of Demand Curve

• Slopes downward

• If Giffen good, slopes upward

• Demand and indifference curves cannot be drawn on same graph– Require different axes


Income and Substitution Effects

• Why no Giffen goods in reality?– When price increases, expect quantity demanded

decrease

• Why this expectation?– Income effect

• Price rises• Can no longer afford previous basket• Decrease (increase) consumption if normal (inferior) good

– Substitution effect• Price rises• Adjust consumption of goods whose price above marginal

value


Isolating the Substitution Effect

• Suppose given just enough money to offset income effect– Compensated: same indifference curve

originally on

• Graph shows reduction in consumption


Combining the Effects

• Know how substitution effect changes consumption

• Can deduce impact of income effect


EXHIBIT 4.8 Constructing the Demand Curve


Why Demand Curves Slope Downward: Normal Goods

• Geometric Observations– Price goes up, substitution effect leads to less

consumption– Move from compensated line to new line,

income falls, consume less of good if normal

• Demand curve for normal good– Both effects move consumer leftward– Normal goods are not Giffen goods


Why Demand Curves Slope Downward: Inferior Goods

• Demand curve for inferior goods– Effects move in opposite directions and not as easily analyzed

as normal good– Inferior good non-Giffen is substitution effect exceeds income

effect– Inferior good Giffen if income effect exceeds substitution effect

• Size of income effect– Income effect of price change large if good large fraction of

consumer expenditures• Giffen goods revisited

– Giffen goods are inferior– Giffen goods account for a large portion of consumer

expenditures– Conditions above explain why so rare


EXHIBIT 4.11 Income and Substitution Effects for an Inferior Good


Compensated Demand Curve

• Curve showing, for each price, what the quantity demanded would be if the consumer were income-compensated for all price changes

• Allows for isolation of substitution effect

• Confirms that compensated demand curve downward sloping


EXHIBIT 4.12 Compensated and Uncompensated Demand Curve


Elasticities

• Anticipate changes in consumer buying habits

• Predictions– If income increases, consumer buys more– In price falls, consumer buys more

• No predictions about magnitude of change– Want to know by how much consumption and

expenditures change


Income Elasticity of Demand

• Depicted by Engel curve

• Could measure response by slope of curve– Slope arbitrary– Dependent on units good X measured in and

units income measured in

• Adopt measure not dependent on units of measurement


Income Elasticity Continued

• If your income increased by one dollar, by how many units would you increase your consumption of X?

• If your income increases by 1%, by what percent would you increase your consumption of X?

• Answer: elasticity of Engel curve– Income elasticity of demand


Income Elasticity Continued

Income elasticity

= IQ

QI

II

QQ

I

Q

/100

/100

%

%


Price Elasticity of Demand

Price elasticity

= PQ

QP

PP

QQ

P

Q

/100

/100

%

%


More about Price Elasticity

• Demand highly elastic when price elasticity of demand has large absolute value

• Why?– Availability of substitutes


Relationship between Income and Price Elasticity of Demand

• Determinants of value of price elasticity of demand – Size of substitution effect– Size and direction of income effect

• Larger for goods that take up large fraction of income • Larger for goods with high income elasticity of demand• Income effect depends on whether good normal or inferior

– Normal: larger income effect means larger price elasticity of demand

– Inferior: larger income effect means smaller price elasticity of demand


Cross Elasticity of Demand

• Change in price of some other good Y may affect demand for X

• Measure size of effect using cross elasticity of demand– Percent change in consumption X divided by the

percent change in the price of Y– Substitutes: cross price elasticity of demand positive– Complements: cross price elasticity of demand

negative• Used to determine level and amount of

monopoly power held by certain firms in antitrust cases

steven landsburg, university of rochester chapter 4 consumers in the marketplace copyright ©2005 by...

Documents

price income

price theory

price of x

function of price

price of good y

demand curve slide

consumption plots price

engel curve slide