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Chapter 4
Consumers in the Marketplace
Steven Landsburg,
University of Rochester
Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.
Introduction
• 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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EXHIBIT 4.3
Normal and Inferior Goods
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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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EXHIBIT 4.4
Constructing the Engel Curve
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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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EXHIBIT 4.7
Non-Giffen Goods and Giffen
Goods
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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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EXHIBIT 4.10 Income and Substitution Effects
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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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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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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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Combining the Effects
• Know how substitution effect changes
consumption
• Can deduce impact of income effect
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EXHIBIT 4.8
Constructing the Demand Curve
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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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EXHIBIT 4.11 Income and Substitution Effects
for an Inferior Good
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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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EXHIBIT 4.12 Compensated and Uncompensated
Demand Curve
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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
=
%Q 100  Q / Q I  Q


%I
100  I / I
Q  I
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Price Elasticity of Demand
Price elasticity
=
%Q 100  Q / Q P  Q


%P 100  P / P Q  P
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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
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