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Chapters 4: Individual and Market Demand
1
Price-Consumption Curve
margarine
Price-Consumption
curve
P=$7
10
20
P=$3
P=$2
32
butter
Price
7
3
Demand for butter
2
10
20
32
Quantity of butter
2
Link Between Indifference Curve Budget
Constraint Model and Demand Curve
• The utility-maximizing quantities at each price level trace out the
individual’s demand curve
P
$15
$10
$5
P=$15
9
12
15
P=$10
P=$5
Q
Q
9
12
15
3
From Individual to Market Demand
• Market demand is made up of the sum of individual
demands
Total Demand
p
p
D1
p
D2
p
D3
p
D4
15
Q
30
Q
25
Q
10
Q
Q
80
4
Income-Consumption and Engel Curves
Oranges
Income
Engel Curve
Income-Consumption
100
Curve
75
50
I = 50
1000
I = 75
2000
2900
I = 100
apples
1000
2000
2900
5
apples
Normal and Inferior Goods
• Normal good - one whose quantity demanded rises as
income rises
• Inferior good - one whose quantity demanded falls as
income rises
Normal
good
Normal
good
6
Normal good
Inferior good
Effect of a Price Change on Utility
• Compensating Variation: The minimum change in
income at the new prices that would make the consumer
as well off as they were before the price change
• Equivalent Variation: The minimum change in income
at the old prices that would make the consumer as well
off as they are after the price change
7
Compensating Variation
Compensating
Variation
8
Equivalent Variation
Equivalent
Variation
9
Income and Substitution Effects
• The total impact of a price change on the demand for a product
can be broken into the income and substitution effects
– Income effect - the component of the total effect of a price change that
results from the associated change in real purchasing power (quasi income)
– Substitution effect - the component of the total effect of a price change that
results from the associated change in the relative attractiveness (relative
price) of the good in question
• Giffen good is one for which the total effect of a price
increase/decrease is to increase/decrease the demand for that good
(counter intuitive effect)
– Substitution effect is always in the same direction so a Giffen good is a
strongly inferior good, so strongly inferior that the income effect is larger
than the substitution effect
10
Effect of a Price Change: Normal Good
All other goods
Substitution
effect
Income
effect
apples
11
Effect of a Price Change: Inferior Good
All other goods
Substitution
effect
Income
effect
Spam
12
Effect of a Price Change: Giffen Good
All other goods
Substitution
effect
Income
effect
Potatoes
13
Price Elasticity
• Price elasticity of demand - the percentage change in the quantity
demanded that results from a 1 percent change in its price
%Q Q P
1 P



0
%P P Q slope Q
• Always less than zero by Law of Demand

• The value of price elasticity tells whether demand is elastic,
inelastic, or
unitary elastic
  1
– Elastic
  1
– Inelastic
  1
– Unitary Elastic


14
Graphical Depiction of Price Elasticity
Price
1 
10
Q P (2 1) 9
9

   Elastic
P Q (9 10) 2
2
9

2 
Q P (10  9) 2
2

   Inelastic
P Q (1 2) 9
9
2
1

1
2
demand
9
10
Quantity
15
Elasticity Along a Demand Curve
Price
Elastic
Unitary Elastic
Inelastic
demand
Quantity
16
Other Elasticities
• Income elasticity of demand - the percentage change in
the quantity demanded that results from a 1 percent
change in income (Y)
%Q Q Y


%Y Y Q
• Cross-price elasticity - the percentage change in the
demand for good X that results from a 1 percent change
 of good Y
in the price
%Qx Qx Py
xy 

%Py Py Qx
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What Determines Price Elasticities
• Substitution possibilities - greater number of substitutes makes
goods more elastic
• Budget share - greater share of expenditures accounted for by the
product, the more elastic
• Direction of income effect - normal goods will have higher price
elasticities than inferior goods b/c the income effect reinforces the
substitution effect
• Time - the longer the time period in question, the greater the price
elasticity
18
Price Elasticity and Total Revenue
(Elastic)
Price
Losses in total revenue
from lowering the price
Gains in total revenue
from lowering the price
Quantity
19
Price Elasticity and Total Revenue
(Inelastic)
Price
Losses in total revenue
from lowering the price
Gains in total revenue
from lowering the price
Quantity
20