Demand and Behavior

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Chapter 4

• Demand and Behavior
• in Markets

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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

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• Optimal consumption bundle

F
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Demand is homogenous

• If income and all prices double, the quantity
  demanded of all goods remains the same
• Reason same budget constraint

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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

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Superior and inferior goods
(b)
(a)
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Homothetic Preferences

• Homothetic preferences
• Indifference curves
• Do not rotate as consumers 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

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Price-Consumption Paths

• Price-consumption path / curve
• Consumption changes
• One price changes
• All other prices constant
• Consumers income constant

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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

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

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• Demand curve for good1

The demand curve for good 1 associates the
optimal quantity of good 1 with its price, while
holding income and other prices constant.
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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 gt p, quantity 0
• If price p, quantity gt 0
• As price decreases, quantity increases

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• Non convex preferences and demand

(b)
(a)
X1m/p1
B
p1
Non-convex preferences imply optimal consumption
bundles at the corners of the feasible seteither
point h or point k.
Demand curve. Non-convex preferences imply jumps
in the demand curve.
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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

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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

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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
• Increase if the good is normal
• Decrease if the good is inferior

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(a)
(b)
Downward-sloping demand curve
The income effect of the price change is 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.
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• Inferior Goods Income and substitution effects
  work on opposite directions

How does the demand curve for good 1 look like?
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 .
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Giffen Goods and Upward-SlopingDemand Curves

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

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• Giffen good

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 ).
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Identifying normal and Giffen goods
Type of good Substitution effect Income effect
Normal downward sloping D Opposite to price change The good is either superior or inferior but with an income effect that is less powerful than the substitution effect.
Giffen Upward sloping D Opposite to price change The good is inferior. The income effect is more powerful than the substitution effect.
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