1 / 70

Chapter 3 Individual Demand Curves

Chapter 3 Individual Demand Curves. Demand Functions. Knowing a person’s preferences and all the economic forces that affect choices allows a prediction of how much of each good a person would choose in the face of scarcity

baker-lynch
Download Presentation

Chapter 3 Individual Demand Curves

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Chapter 3 Individual Demand Curves

  2. Demand Functions • Knowing a person’s preferences and all the economic forces that affect choices allows a prediction of how much of each good a person would choose in the face of scarcity • Summarizes this information in a demand function: a representation of how the quantity demanded depends on prices, income, and preferences.

  3. Demand Function • Three elements determine quantity demanded: • Prices of X and Y • Income (I) • Person’s preferences for X and Y. • Preferences appear to the right of semicolon - assume that preferences do not change during analysis (i.e. it is static) {3.1}

  4. Changes in Income • When income increases and prices remain the same, the quantity of each good purchased might increase. • Shown in Figure 3-1 where an increase in income shows as a shift of budget line outward from I1 to I2 to I3. • Slope of budget lines remain the same because prices have not changed .

  5. FIGURE 3-1: Effect of Increasing Income on the Quantities of X and Y Chosen

  6. FIGURE 3-1: Effect of Increasing Income on the Quantities of X and Y Chosen

  7. FIGURE 3-1: Effect of Increasing Income on Quantities of X and Y Chosen Quantity of Y per week Y3 Y2 U3 U2 Y1 U1 I2 I3 I1 Quantity of X per week 0 X1 X2 X3

  8. Changes in Income • Response to increased income: quantity of X purchased increases from X1 to X2 and X3 while the quantity purchased of Y also increases from Y1 to Y2 to Y3. • Income increases allow more consumption, and are reflected in an outward shift in the budget constraint. Allows an increase in overall utility.

  9. Normal Goods & Inferior Goods • Normal good: bought in greater quantities as income increases • Inferior good: bought in smaller quantities as income increases.

  10. FIGURE 3-2: Indifference Curve Map Showing Inferiority Quantity of Y per week Y1 U1 Quantity of Z per week I1 Z1 0

  11. FIGURE 3-2: Indifference Curve Map Showing Inferiority Quantity of Y per week Y2 U2 Y1 U1 I2 I1 Quantity of Z per week Z2 Z1 0

  12. FIGURE 3-2: Indifference Curve Map Showing Inferiority Quantity of Y per week Y3 U3 Y2 U2 Y1 U1 I1 I2 I3 Quantity of Z per week Z2 Z1 0 Z3

  13. Changes in a Good’s Price • Change in the price of one good causes both slope and the intercept of the budget line to change. • Change in one good’s price creates a new utility-maximizing choice on another indifference curve with a different MRS. • Change in quantity demanded of good with price change

  14. Substitution Effect • Part of the change in the quantity demanded for other goods is caused by the substitution of one good for another: called substitution effect • Movement along an indifference curve • Consumption has to change to equate MRS to the new price ratio of the two goods.

  15. Income Effect • Price change creates difference in real purchasing power; consumers move to a new indifference curve consistent with their new purchasing power • Part of the change in the quantity demanded is caused by the change in real income: called income effect.

  16. Substitution and Income Effects from a Fall in Price • Figure 3-3: when the price of good X falls, the budget line rotates out from the unchanged Y axis, such that the X intercept lies farther out - the consumer can now buy more X with lower price. • Flatter slope means that relative price of X to Y (PX/PY) has fallen.

  17. FIGURE 3-3: Income and Substitution Effects of a Fall in Price Quantity of Y per week Y* U1 Quantity of X per week 0 X*

  18. FIGURE 3-3: Income and Substitution Effects of a Fall in Price

  19. FIGURE 3-3: Income and Substitution Effects of a Fall in Price

  20. Figure 3-4: Relative Size of Substitution Effects Right Shoes Shell . A,B U1 I I’ I’ I U1 BP Left Shoes (a) Small Substitution Effect ’ (b) Large Substitution Effect

  21. Substitution and Income Effects from an Increase in Price • Increase in PX will shift budget line in toward origin, as in Figure 3-5. • Substitution effect, holding “real” income constant: move on U2 from X*, Y* to point B • Because a higher price decreases purchasing power, movement from B to X**, Y** is the income effect

  22. FIGURE 3-5: Income and Substitution Effects of an Increase in Price Quantity of Y per week U2 New budget constraint Y* Old budget constraint Quantity of X per week 0 X*

  23. FIGURE 3-5: Income and Substitution Effects of an Increase in Price Quantity of Y per week U2 U1 B New budget constraint Y* Old budget constraint Quantity of X per week 0 XB X* Substitution effect

  24. FIGURE 3-5: Income and Substitution Effects of an Increase in Price

  25. Substitution and Income Effects for a Normal Good: Summary • Figures 3-3 and 3-5 show that substitution and income effects work in the same direction with a normal good. • When the price falls, both substitution and income effects result in more being purchased. • When price increases, both substitution and income effects result in less being purchased.

  26. Substitution and Income Effects for a Normal Good: Summary • These effects provide a rationale for downward sloping demand curves. • Also help to determine steepness of demand curve • If either substitution or income effects are large, the change in quantity demanded will be large with a given price change.

  27. Substitution and Income Effects for Inferior Goods • With an inferior good, the substitution and income effects work in opposite directions. • Substitution effect results in decreased consumption for price increases and increased consumption for price decreases.

  28. FIGURE 3-6: Income and Substitution Effects for Inferior Good Quantity of Y per week Y* U2 Old budget constraint Quantity of X per week 0 X*

  29. Substitution and Income Effects for Inferior Goods • For inferior goods, the income effect results in an increased consumption for a price increase, and decreased consumption for a price decrease. • Figure 3-6 shows income and substitution effects for an increase in PX. • Substitution effect, holding real income constant, appears as a move from X*, Y* to point B both on U2.

  30. FIGURE 3-6: Income and Substitution Effects for Inferior Good Quantity of Y per week B New budget constraint Y* U2 Y** Old budget constraint U1 Quantity of X per week 0 X*

  31. FIGURE 3-6: Income and Substitution Effects for Inferior Good Quantity of Y per week B New budget constraint Y* U2 Y** Old budget constraint U1 Quantity of X per week 0 X** X*

  32. Substitution and Income Effects: Inferior Goods • Income effect reflects reduced purchasing power due to a price increase. • X is an inferior good: decreased income results in increased consumption of X - shown by a move from point B on U1 to a new utility maximizing point X**, Y** on U1.

  33. Substitution and Income Effects for Inferior Goods • Since X** is less than X*, X price increase results in a decreased consumption of X. • Decreased consumption happens because the substitution effect, in this example, is bigger than the income effect. • Thus, if the substitution effect dominates, the demand curve is negatively sloped.

  34. Giffen’s Paradox • If the income effect of price change for an inferior good is strong enough, the quantity demanded may change in same direction as the price change. • A situation in which an increase in a good’s price, leads people to consume more of the good is called Giffen’s paradox.

  35. The Lump Sum Principle • “Lump-sum principle” holds that taxes imposed on general purchasing power will have smaller welfare costs than will taxes imposed on a narrow selection of commodities. • Consider Figure 3-7: an individual initially has I euros to spend, and chooses to consume X* and Y*, yielding U3 utility.

  36. FIGURE 3-7: The Lump-Sum Principle Quantity of Y I Y* U3 Quantity of X per week X*

  37. The Lump Sum Principle • A tax on only good X raises its price, resulting in a budget constraint I*, and consumption reduced to X1, Y1 and utility level U1. • A general income tax that generates the same total tax revenue is represented by the budget constraint I** that goes though X1, Y1.

  38. FIGURE 3-7: The Lump-Sum Principle Quantity of Y I Y1 Y* I’ Y2 U3 U1 Quantity of X per week X1 X*

  39. FIGURE 3-7: The Lump-Sum Principle Quantity of Y I Y1 Y* I’ I” Y2 U3 U2 U1 Quantity of X per week X1 X2 X*

  40. The Lump Sum Principle • Intuitive explanation of lump-sum principle: a single-commodity tax affects consumers in two ways: • Reduces their purchasing power, • Directs consumption away from the good being taxed. • The lump-sum tax only has the first of these two effects.

  41. Changes in the Price of Another Good • In a two-good economy, when the price of one good changes, it affects the demand for the other good. • Figure 3-3: an increase in the price of X (a normal good) caused both an income and substitution effect that caused a reduction in the quantity demanded of X.

  42. Changes in the Price of Another Good • In addition, the substitution effect caused the demand to decrease for good Y as the consumer substituted good X for good Y. • To offset, the purchasing power increase brought about by a price decrease, causes an increase in the demand for good Y (also a normal good).

  43. Changes in the Price of Another Good • In this case, the income effect had a dominant effect on good Y - consumption of Y increased due to the decrease in X’s price. • With flatter indifference curves as shown in Figure 3-8, the situation reverses. • Decrease in X’s price causes a decrease in the consumption of good Y, as before.

  44. FIGURE 3-8: Effect on the Demand for Good Y of a Decrease in the Price of Good X Quantity of Y per week Old budget constraint Y* U1 Quantity of X per week 0 X*

  45. FIGURE 3-8: Effect on the Demand for Good Y of a Decrease in the Price of Good X Quantity of Y per week Old budget constraint A Y* B New budget constraint U2 U1 Quantity of X per week 0 X*

  46. FIGURE 3-8: Effect on the Demand for Good Y of a Decrease in the Price of Good X Quantity of Y per week Old budget constraint A Y* C Y** B New budget constraint U2 U1 Quantity of X per week 0 X* X**

  47. Changes in the Price of Another Good – Substitutes & Complements • Here, the income effect is much smaller than the substitution effect, so the consumer ends up consuming less of good Y at Y** after a decrease in X’s price. • Thus, the effect of a change in the price of one good has an ambiguous effect on demand for the other good.

  48. Construction of Individual Demand Curves • Individual demand curve: is a graphic representation between the price of a good and the quantity demanded by a consumer, holding all other factors (preferences, prices of other goods, and income) constant • Demand curves limit the study to the relationship between the quantity demanded and changes in the good’s price - a single good world

  49. Construction of Individual Demand Curves • Panel a of Figure 3-9: an individual’s indifference curve map drawn using three different budget constraints - Px decreases • Decreasing prices: P’X, P”X, and P’’’X respectively • Individual’s utility maximizing choices of quantity of X: X’, X’, and X’’’ respectively

  50. FIGURE 3-9: Construction of Individual’s Demand Curve

More Related