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Chapter 4 More Demand Theory 4/1 © 2009 Pearson Education Canada The Law of Demand The law of demand implies an inverse relationship between price and quantity demanded. When the price and quantity of a good are positively related, the good is called a Giffen Good. 4/2 © 2009 Pearson Education Canada Income and Substitution Effects The substitution effect of a change in p1 is associated with the relative change in the price of good 1. The income effect of a change in p1 is associated with the change in real income. 4/3 © 2009 Pearson Education Canada Figure 4.1 A Giffen good 4/4 © 2009 Pearson Education Canada Figure 4.2 Income and substitution effects for a price increase 4/5 © 2009 Pearson Education Canada Figure 4.3 Income and substitution effects for a price decrease 4/6 © 2009 Pearson Education Canada Income and Substitution Effects If indifference curves are smooth and convex and if the consumer buys a positive quantity of both goods, then the substitution effect is always negatively related to the price change. For a normal good, the income effect is negatively related to the price change. For an inferior good, the income effect is positively related to the price change. 4/7 © 2009 Pearson Education Canada Compensatory Income After a price change, the minimum income that allows the consumer to attain the original indifference curve is called the compensatory income. The budget line associated with the compensatory income is the compensated budget line. 4/8 © 2009 Pearson Education Canada Figure 4.4 The nonpositive substitution effect 4/9 © 2009 Pearson Education Canada The Compensated Demand Curve The compensated demand curve identifies the consumer’s utility maximizing bundle when, as a result of a price change, the consumer’s income is adjusted to keep him/her on the same indifference curve. The compensated demand curve reflects the substitution effect and cannot be upward sloping. 4/10 © 2009 Pearson Education Canada Figure 4.5 The compensated demand curve 4/11 © 2009 Pearson Education Canada Compensating and Equivalent Variation Equivalent variation identifies the variation in income that is equivalent to being able to buy good x at a given price. Compensating variation identifies the variation in income that compensates for the right to buy good x at a given price. 4/12 © 2009 Pearson Education Canada Figure 4.8 Measuring the benefit of a new good 4/13 © 2009 Pearson Education Canada From Figure 4.8 Mr. Polo’s non-member initial equilibrium is E0 on I0. Equilibrium as a member is E1 on I1. Equivalent variation is EV. With no membership, this additional income would yield indifference curve I1. Compensating variation is CV. Given that he is a member, this reduction in income yields indifference curve I0. 4/14 © 2009 Pearson Education Canada Figure 4.9 Measuring the cost of a price change 4/15 © 2009 Pearson Education Canada From Figure 4.9 Low price of P1 gives equilibrium of E0 on I0. Equilibrium with higher price of P1 is at E1 on I1. With a lower price, reducing income by EV yields I1. With a higher price, increasing income by CV would yield I0. 4/16 © 2009 Pearson Education Canada Figure 4.10 The case in which CV equals EV 4/17 © 2009 Pearson Education Canada Figure 4.11 Consumer’s surplus for a new good 4/18 © 2009 Pearson Education Canada Figure 4.12 Consumer’s surplus for a price reduction 4/19 © 2009 Pearson Education Canada Figure 4.13 Marginal values and marginal rates of substitution 4/20 © 2009 Pearson Education Canada Figure 4.14 Total value and marginal value 4/21 © 2009 Pearson Education Canada Figure 4.15 Equal marginal values 4/22 © 2009 Pearson Education Canada Application: Two Part Tariff What combination of camera price (pc) and film price (p1) maximize profits? The cost of producing a camera is $5, the cost of making film is 1$. The firm’s profit maximizing strategy is to sell the film at cost and charge the corresponding reservation price for the camera, area GAF (Fig 4.16). 4/23 © 2009 Pearson Education Canada Figure 4.16 The Polaroid pricing problem 4/24 © 2009 Pearson Education Canada Figure 4.17 The Paasche quantity index 4/25 © 2009 Pearson Education Canada Paasche Quantity Index 1 1 1 1 1 0 1 0 P ( p x p x ) /( p x p x ) 1 1 2 2 1 1 2 2 1 0 If P exceeds 1 then B is preferred to B 4/26 © 2009 Pearson Education Canada Laspeyres Quantity Index 0 1 0 1 0 0 0 0 L ( p x p x ) /( p x p x ) 1 1 2 2 1 1 2 2 0 1 If L 1, then B is preferred to B 4/27 © 2009 Pearson Education Canada Price Indices Paache Pr ice Index P ' ( p1x1 p1 x1 ) /( p 0 x1 p 0 x1 ) 11 2 2 1 1 2 2 Laspeyres Pr ice Index L' ( p1x 0 p1 x 0 ) /( p 0 x 0 p 0 x 0 ) 11 2 2 1 1 2 2 When L' is less than 1, then P' is also less than 1, and you are better off in period 1. When P' is greater than 1, then L' is aslo greater than1, and you are better off in period 0. 4/28 © 2009 Pearson Education Canada Figure 4.18 An index-number puzzle 4/29 © 2009 Pearson Education Canada