Chapter 4 Consumers in the Marketplace

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Chapter 4Consumers in the Marketplace

• 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

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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

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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

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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

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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

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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

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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

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Shape of Demand Curve

• Slopes downward
• If Giffen good, slopes upward
• Demand and indifference curves cannot be drawn on
  same graph
• Require different axes

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Isolating the Substitution Effect

• Suppose given just enough money to offset income
  effect
• Compensated same indifference curve originally
  on
• Graph shows reduction in consumption

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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

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Combining the Effects

• Know how substitution effect changes consumption
• Can deduce impact of income effect

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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

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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

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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

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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

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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

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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

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Income Elasticity Continued

• Income elasticity

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Price Elasticity of Demand

• Price elasticity

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More about Price Elasticity

• Demand highly elastic when price elasticity of
  demand has large absolute value
• Why?
• Availability of substitutes

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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

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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