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PPA 723: Managerial
Economics
Lecture 8:
Deriving Demand Curves
Managerial Economics, Lecture 8: Deriving Demand Curves
Outline
Deriving Demand Curves
Income Elasticities of Demand
Income and Substitution Effects
Managerial Economics, Lecture 8: Deriving Demand Curves
Deriving Demand Curves
Trace out the demand curve for Good B
from a household-maximization diagram by
holding income and the price of Good A
constant
and varying the price of Good B
Then plot the price-quantity pairs in a new
graph.
Managerial Economics, Lecture 8: Deriving Demand Curves
Pulling Out Price and Quantity Combinations
B, Burritos
per semester
Price of Pizza Doubles
25
L 1 (p Z = $1)
Price-Consumption
Curve
L 2 (pZ = $2)
0
15
25 27
50
Z, Pizzas per semester
Managerial Economics
Deriving Demand Curves
(a) Indifference Curves and Budget Constraints
Wine, Gallons
per year
12.0
Price-consumption curve
Figure 5.1 Deriving
an Individual’s
Demand Curve
e3
5.2
e2
4.3
2.8
I3
e1
I2
I1
L 1 (pb = $12)
0
26.7
44.5
L2 (pb = $6)
58.9
p b, $ per unit
12.0
Beer, Gallons per year
(b) Demand Curve
E1
E2
6.0
E3
4.0
0
L 3 ( pb = $4)
D1, Demand for beer
26.7
44.5
58.9
Beer, Gallons per year
Managerial Economics, Lecture 8: Deriving Demand Curves
How Income Changes Shift Demand Curves
In household-maximization diagram,
hold prices fixed and vary income.
The increase in income causes
movement along the incomeconsumption curve,
shift of the demand curve,
movement along the Engel curve.
Managerial Economics, Lecture 8: Deriving Demand Curves
Income-Consumption Curve
An increase in income shifts the budget
line outward.
An income-consumption curve plots
combinations of Good A and Good B at
different income levels.
Managerial Economics, Lecture 8: Deriving Demand Curves
Shifts in the Demand Curve
Recall that a demand curve plots pricequantity combinations for one good.
A change in income changes the
quantity for a good, holding price
constant.
So at each price, plot how quantity
consumed increases with income.
Managerial Economics, Lecture 8: Deriving Demand Curves
Engle Curves
An Engle curve plots quantity
consumed for a good (X-axis) against
income (Y-axis), holding prices
constant.
It shows how consumption of a good
changes as income changes.
Managerial Economics, Lecture 8: Deriving Demand Curves
Pulling Out Income and Quantity Combinations
Income Doubles
B, Burritos
per semester
50
L 3 (Y = $100)
Income-Consumption
Curve
25
L 1 (Y = $50)
0
25
50 55
100
Z, Pizzas per semester
Indifference Curves and Budget Constraints
Managerial Economics, Lecture 8:(a)
Deriving
Demand Curves
Wine, Gallons
per year
L3
L2
Income-consumption
curve
L1
e3
Figure 5.2 Effect of a Budget
Increase on an Individual’s
Demand Curve
7.1
4.8
2.8
e2
e1
I1
0
26.7 38.2 49.1
I3
Beer, Gallons per year
(b) Demand Curves
Price of beer,
$ per unit
12
I2
E1
E2
E3
D3
D2
D1
0
26.7 38.2 49.1
Beer, Gallons per year
(c) Engel Curve
Y, Budget
Engel curve for beer
Y3 = $837
E3*
Y2 = $628
Y1 = $419
0
E2*
E 1*
26.7 38.2 49.1
Beer, Gallons per year
Managerial Economics, Lecture 8: Deriving Demand Curves
Income Elasticities
Income elasticity:
percentage change in quantity demanded

percentage change in income
Q / Q

Y / Y
Normal good:  > 0
Inferior good:   0
Note:  is Greek xi (pronounced ks-eye).
Managerial Economics, Lecture 8: Deriving Demand Curves
Income-Consumption Curves
and Income Elasticities
The shape of the income-consumption
curve for 2 goods reveals the sign of the
income elasticities.
Some goods must be normal; not all
goods can be inferior.
Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.3 Income-Consumption Curves and Income Elasticities
Housing, Square feet
per year
Food inferior,
housing normal
L2
ICC 1
a
Food normal,
housing normal
ICC 2
b
L1
e
c
ICC 3
Food normal,
housing inferior
I
Food, Pounds per year
Managerial Economics, Lecture 8: Deriving Demand Curves
Applications to Policy
Policy makers may care about the
consumption of particular goods, such
as health care or housing.
If we know income elasticities, we can
predict the extent to which people buy
more of these goods when
they receive a cash grant
incomes in general rise.
Managerial Economics, Lecture 8: Deriving Demand Curves
The Effects of a Price Change
As price of Good A goes up (all else the
same), there are two impacts in the
quantity of Good A that is consumed:
the substitution effect
the income effect
Managerial Economics, Lecture 8: Deriving Demand Curves
Substitution Effect
Consumers substitute other, now
relatively cheaper, goods for the good
subject to a price increase.
The direction of the substitution effect is
unambiguous: It is always negative!
Managerial Economics, Lecture 8: Deriving Demand Curves
Income Effect
An increase in the price of Good A reduces
a consumers' buying power, thereby
reducing his or her real income.
A change in real income is equivalent to a
change in money income holding prices
constant, so
The direction of the income effect depends
on the income elasticity of Good A
Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects
price rise
income effect
normal good
substitution
effect
negative
inferior good
negative
positive
negative
Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.5 Substitution and Income Effects with Normal Goods
Wine, Gallons
per year
12.0
L2
L1
e2
5.5
L*
I2
e1
e*
I1
0
26.7 30.6
Substitution
effect
58.9
Income effect
Total effect
Beer, Gallons per year
Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects with
an Inferior Good
 The substitution effect and the price change
still have opposite signs.
 The income effect and the price change have
the same signs.
 A Giffen good: good for which a decrease in its
price causes the quantity demanded to fall
(because the positive income effect is so large!)
Managerial Economics, Lecture 8: Deriving Demand Curves
Basketball,
Tickets per year
Figure 5.6 Giffen Good
L2
L1
e2
I2
L*
e1
e*
I1
Substitution effect Movies, Tickets per year
Total effect
Income effect
Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects: Lessons
 Income and substitution effects help identify
consumer’s responses to changes in prices.
 As we will see next time, they are very useful in
predicting consumer’s responses to government
programs that alter prices (as many do!).