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Consumer Theory
Demand
Dr. Jennifer P. Wissink
©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved.
Getting The Demand Curve From
The Consumer Problem

C
Budget
Line

C*
Indifference
Curve
B*
B
Once we find the solution to
the consumer choice
problem, how can we use
that to determine the
consumer’s demand curves?
The plan:
– To get the demand curve
for beans, ONLY change
the price of beans, and then
track how Maryclaire’s
optimal bundle changes.
– In this way we get
Maryclaire’s demand curve
for beans.
– Then do the same thing for
Maryclaire with respect to
carrots.
Maryclaire’s Budget At Three
Different Bean Prices
 Holding
Maryclaire's Budget Constraints
30
25
20
Carrots
Income
constant, the three
budget lines
illustrated on this
slide correspond to
per pound bean
prices of $4 (green),
$2 (red) and $1
(blue).
Price of Beans Varies
4
15
2
1
10
5
0
0
5
10
Beans
15
20
Maryclaire’s Demand For
Beans

The best choice is the
point of tangency
between the budget
line and the
indifference curves.
Maryclaire's Demand for Beans
30
25
I2
I1
I0
4
2
1

A, B, and C mark the
best choices as the
price of beans
changes from $4 to $2
to $1.
Carrots
20
15
C
B
10
A
5
0
0
5
10
Beans
15
20
Maryclaire’s Demand For
Beans – Table Summary

The table shows the
amount of beans that
Maryclaire demands at
each price.
Maryclaire's Demand for Beans
Quantity
Price Points
5.5
4
A
10
2
B
18
1
C
Maryclaire's Demand for Beans
The table shows the
beans demanded at the
points of tangency from
the indifference curve &
budget line diagram.
30
25
I2
I1
I0
4
2
1
20
Carrots

15
C
B
10
A
5
0
0
5
10
Beans
15
20
Maryclaire’s Demand For
Beans - Graphed



When the price of beans is
$4/lb, Maryclaire demands
5.5 lbs of beans (A).
When the price of beans is
$2/lb, Maryclaire demands
10 lbs of beans (B).
When the price of beans is
$1/lb, Maryclaire demands
18 lbs of beans (C).
Her demand curve is
shown at the right, again.
A
4
3
Price

Maryclaire's Demand for Beans
2
B
1
C
0
0
2
4
6
8 10 12 14 16 18 20
Quantity
The Law Of Demand:
Total, Substitution & Income Effects

Question: Will a demand curve ALWAYS be downward
sloping?

Economists decompose the total effect of a change in price
on the quantity demanded into an income and a
substitution effect.

Income effect: due to the increase in real income
associated with a fall in prices (you can buy more with the
same nominal income) or the loss of real income
associated with a rise in prices (you cannot buy as much as
you once did with the same nominal income).

Substitution effect: due to the change in the relative price of
the good, cheaper goods are substituted for more
expensive ones.
Reacting To A Price Change:
Total, Substitution and Income Effects
Suppose the PX falls
SUBSTITUTION EFFECT
INCOME EFFECT
You feel richer – your dollars now buy more
“X” normal
Quantity of X
demanded increases
X now looks relatively cheaper
“X” inferior
Quantity of X
demanded
decreases
Quantity of X demanded increases
Quantity of X demanded increases
Quantity of X demanded might increase OR decrease
Moral of the Story:
Total, Substitution and Income Effects






Total Effect  the market observed response to a price change
Substitution Effect  the response to the fact that relative prices
have changed, ONLY.
Income Effect  the response to the fact that real income has
changed, ONLY.
Total Effect = Substitution Effect + Income Effect
Question: Is the “own price” total effect always negative (so that
we get the “law of demand”)?
Answer: (NOTE: This is for “own price” changes!)
– If X is a normal good, then YES.
– If X is an inferior good, then provided the substitution effect
outweighs the income effect, YES.
– If X is an inferior good, then if the income effect outweighs the
substitution effect, NO. Note: Then the good is said to be a
Giffen good.
Maryclaire’s Best Choices
Compared at 2 Prices



The point A corresponds to
the best choice when PB=$4.
The point C corresponds to
the best choice when PB=$1.
The conditions of optimality
are satisfied at both points-the slope of the indifference
curve (MUB/MUC) equals the
slope of the budget
constraint (PB/PC).
All other variables have been
held constant: I=$40 and
PC=$2.
Maryclaire's Demand for Beans
30
25
20
Carrots

I2
I0
4
1
15
C
10
A
5
0
0
5
10
Beans
15
20
Maryclaire’s Income and
Substitution Effects


Graph shows the income and
substitution effects of the fall in
the price of beans from $4/lb (A)
to $1/lb (C).
The movement from point A to
point D is the substitution effect:
Maryclaire buys less carrots and
more beans, and would do so
even if she had an income of
only $20 (as the black budget
line shows).
The movement from point D to
point C is the income effect, the
price decline is like giving
Maryclaire an additional $20 of
real income.
Maryclaire's Income and Substitution
Effects
30
25
I2
I0
4
1
1
20
Carrots

15
C
A
10
D
5
0
0
5
10
Beans
15
20
Maryclaire’s Substitution
Effect

The substitution effect is the
amount by which Maryclaire’s
bean consumption increased
holding real income constant.
The substitution effect is the
difference between Maryclaire's
consumption of beans at the
new and old prices holding her
real income constant; that is,
staying on the same
indifference curve (compare
points A and D).
Maryclaire's Income and Substitution
Effects
30
25
I2
I0
4
1
1
20
Carrots

15
C
A
10
D
5
0
0
5
10
Beans
15
20
Maryclaire’s Income Effect


When the price of beans falls
from $4/lb to $1/lb, Maryclaire is
able to buy both more beans
and more carrots.
The income effect is the
difference between what she
would have bought on the old
indifference curve at the lower
bean price (point D) and what
she actually did buy with her
nominal income ($40) at the
lower price (point C).
Maryclaire increases her
consumption of beans and
carrots because of the increase
in her real income from the price
decline.
Maryclaire's Income and Substitution
Effects
30
25
I2
I0
4
1
1
20
Carrots

15
C
A
10
D
5
0
0
5
10
Beans
15
20
Maryclaire’s Income and
Substitution Effects: Summary



The original point is A.
The substitution effect
is the movement from
A to D on the same
indifference curve.
The income effect is
the movement from D
to C on the new
indifference curve.
The optimal choice is
now C.
Maryclaire's Income and Substitution
Effects
30
25
I2
I0
4
1
1
20
Carrots

15
C
A
10
D
5
0
0
5
10
Beans
15
20
From Individual to Market
Demand
 Market
demand is the sum of all individual
demands in the economy.
 So what ever happened to Katie?
 Let’s bring her back into the story.
 She is solving the same consumer theory
problem as Maryclaire, except with HER
preferences and HER income level, but the
SAME market prices for beans and carrots.
 The market demand, then, is the sum of the
quantities demand by Maryclaire and Katie at
each market price.
Katie’s Demand For Beans



Katie’s income is $40.
Katie faces the same
prices for carrots as
Maryclaire: $2/lb.
Her preferences are
different from
Maryclaire’s.
Her demand for beans is
derived in the figure using
indifference curves and
budget constraints.
Katie's Demand for Beans
30
25
Carrots

I2
I1
I0
4
2
1
20
C
15
B
10
A
5
0
0
5
10
Beans
15
20
Chart of Katie’s Demand For
Beans
 The
chart
summarizes the
points of tangency
of the indifference
curves and budget
lines.
 For the indicated
prices, the
quantities shown
set MRS=ERS.
Katie's Demand for Beans
Quantity
Price Point
6.0
4
A
10
2
B
16
1
C
Graph Of Katie’s Demand For
Beans


The points A, B and C in
the chart and on the
indifference curve graph
correspond to Katie’s best
choices given her income
and the three prices of
beans illustrated.
The graph shows her
demand curve for beans.
Notice that her demand
curve is not the same as
Maryclaire’s.
Katie's Demand for Beans
A
4
3
B
Price

2
C
1
0
0
2
4
6
8 10 12 14 16 18 20
Quantity
Market Demand for Beans



The market demand (green) is
the sum of Katie’s (blue) and
Maryclaire’s (red) demand for
beans at each price.
At PB=4, Katie demands 6 lbs,
Maryclaire demands 5.5 lbs.
The market demand is 11.5 lbs.
At PB=2, Katie and Maryclaire
each demand 10 lbs. The
market demand is 20 lbs.
At PB=1, Katie demands 16 lbs,
Maryclaire demands 18 lbs.
The market demand is 34 lbs.
Market for Beans
4
Katie's Demand
Price of Beans

Maryclaire's Demand
3
Market Demand
2
1
0
0
10
20
30
Quantity of Beans
40
Market Demand Questions
Market for Beans
Katie's Maryclaire's Market
Price
Demand
Demand
Demand
1.00
16
18
34
2.00
10
10
20
4.00
6
5.5
11.5
 Question
A: at a market price of $1.50 for beans,
what is the market quantity demanded?
 Question B: at a market price of $3.00 for beans,
what is the market quantity demanded?
Market Demand Answers
Market for Beans (expanded)
Katie's Maryclaire's Market
Price
Demand
Demand
Demand
1.00
16
18
34
1.50
13.0
14.0
27.0
2.00
10
10
20
3.00
8.0
7.75
15.75
4.00
6
5.5
11.5
 Question
A: at a market price of $1.50 for beans,
what is the market quantity demanded? 27
 Question B: at a market price of $3.00 for beans,
what is the market quantity demanded? 15.75
Market Demand

How does our scratch demand compare to the one we
bought off the shelf?

Recall the demand function for X (CD players):
QD = f(PX, Ps, Pc, I, T&P, Pop)
Where:
PX = X’s price
Ps = the price of substitutes
Pc = the price of complements
I=income
Budget set
T&P=tastes and preferences  preferences
Pop=population in market or market size  summing up over people