Demand Theory

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Summary Chapter 5
Demand Theory
2
Price-Consumption Path

• When the price of good 1 is reduced, but the
  income and the price of good 2 remain constant
• the budget constraint line rotates to the right
  (only x- intercept Y/P1 changes).
• the agent can attain a higher indifference curve.
• Price-Consumption Path Is the set of optimal
  bundles that results when the price of one good
  changes but the prices of other goods and the
  consumers income remain constant.

3
Demand Curve

• Demand Curve represents graphically the
  relationship between the quantity of a good
  demanded and the price of that good, as the price
  of that good varies, keeping constant the
  consumers income and the prices of the other
  goods.

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Quantities Demanded

• An example two goods, egg rolls e and sushi
  pieces s income of the agent Y 80 Pe
  2 each, Ps 3 per piece preferences of agent
  are expressed in her utility function U e s.
  Which of the following bundles contain quantities
  demanded for goods e and s respectively a
  (25,10), b (15,10), c (20,40/3)?
• The quantities (e,s) are on the demand curves for
  goods e and good s, respectively (are quantities
  demanded by the agent) if
• at the bundle (e,s), the slope of the
  indifference curve is equal to the slope of the
  budget constraint.
• bundle (e,s) is economically feasible
• You need to check bundle by bundle if the two
  conditions are satisfied.

5
Income-Expansion Path and Engel Curve

• Income-Expansion Path shows how a consumer
  changes his quantity demanded of specific goods
  as his income changes and prices remain constant.
• Engel Curve shows the relationship between
  quantity demanded of a good and income, holding
  prices constant.

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Income Elasticity

• Measures the sensitivity of consumer demand for a
  product to changes in his/her income. We mean by
  sensitivity, the percentage change in the
  quantity demanded of a good that results from a
  given percentage change in the consumers income.
• Let ? be the income elasticity of demand. Then,
• ? percentage change in quantity demanded/
  percentage change in income

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Superior and Inferior Goods

• Superior good type of good for which demand
  increases as the income of the consumer increases
  and the relative prices remain constant (? ? 0).
• Inferior good a good for which demand decreases
  as the income of the consumer increases and the
  relative prices remain constant (? lt 0).

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Total Effect of a Change in the Price of a Good
on the Quantity Demanded of that Good

• The total effect of a change in the price of a
  good on its quantity demanded can be decomposed
  into two effects
• Income effect
• Substitution effect

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Income and Substitution Effects

• Income Effect the reduction of price of good x,
  increases the real income (Yreal) or purchasing
  power of the agent. Now, the agent can buy more
  units of at least one good.
• The effect of the increase in purchasing power
  (Yreal) due to a reduction in the price of one
  good will increase or decrease the quantity
  demanded of the good, depending on the type of
  good (superior or inferior goods).
• Substitution Effect if we isolate the income
  effect (effect the reduction on the price of x
  has on the real income of the agent) and hold
  the consumers utility constant under the new
  relative prices, we get the substitution effect.
• By the substitution effect, a reduction in the
  price of a good will make that good relatively
  cheaper and the consumer substitutes the
  relatively cheaper good for the relatively
  expensive one. Then the quantity demanded of x
  will ALWAYS increase.

10
Normal and Giffen Goods