Chapter 4
Demand and Behavior
in Markets
•2
Impersonal Markets
 Impersonal


Prices: fixed and predetermined
Identity & size of traders – doesn’t matter
 Consumers


markets
represented by
Utility function/ preference map
income
•3
The Problem of Consumer
Choice
 Maximize

Indifference curve tangent to budget line
 MRS

= price ratio
On budget line
 Quantity

utility
demanded of a good
People seek to purchase at a given price
•4
Good 2 (x 2)
 Optimal
20
consumption bundle
B
e
I3
I2
F
0
I1
x1 + x2 = 20
B’
20
Good 1 (x 1)
•5
Income Expansion Paths
 Income

expansion path
Changes in quantity demanded
 Changes
in income
 Constant prices


Connected optimal consumption bundles
MRS = slope of budget line
Good 2 (x 2)
•6
60
40
D
Income expansion path
C
s
20 B
r
e
0
B’
20
C’
40
D’
60 Good 1 (x 1)
•7
Inferior and Superior Goods
 Superior

good
Income increase
 Demand
increases
 Constant relative prices
 Inferior

good
Income increase
 Demand
decreases
 Constant relative prices
•8
0
(a)
Good 2 (x 2)
Good 2 (x 2)
Superior and inferior goods
Good 1 (x 1)
0
(b)
Good 1 (x 1)
•9
Homothetic Preferences

Homothetic preferences

Indifference curves


Along any ray from the origin



MRS – constant
Increase in income


Do not “rotate” as consumer’s income increases
Proportional increase in goods purchased
All goods are superior
No change in tastes
•10
Good 2 (x 2)
60
40
D
Income expansion path
C
s
20 B
r
e
0
B’
20
C’
40
D’
60 Good 1 (x 1)
•11
Price-Consumption Paths
 Price-consumption




path / curve
Consumption changes
One price changes
All other prices – constant
Consumer’s income – constant
•12
Price-Consumption Paths
 Changing

relative prices
Optimal bundle
 Indifference
curve tangent to budget line
 MRS = Price ratio

Good 1 – relatively less expensive
 Rotation

of budget line – flatter
Good 1 – relatively more expensive
 Rotation
of budget line – steeper
•13
Good 2 (x 2)
20 B
-1
1/2 1
2
e
B”
0
10
B’
20
B*
40 Good 1 (x 1)
As the price of good 1 decreases while the price of good 2 remains constant, the
budget line becomes flatter, rotating around its point of intersection with the
vertical axis (point B).
•14
Good 2 (x 2)
20 B
-1
1/2 1
2
e
B”
0
B’
10 15 20
B*
40 Good 1 (x 1)
As the price of good 1 decreases while the price of good 2 remains constant, the
budget line becomes flatter, rotating around its point of intersection with the
vertical axis (point B).
•15
Good 2 (x 2)
B
Price-consumption path
g
f
0
B”
a
e
B’
b c
B*
Good 1 (x 1)
As the price of good 1 varies, the price-consumption path traces the locus of
tangencies between budget lines and indifference curves.
•16
Demand Curves
 Demand

curve
Relationship between
 Quantity
demanded
 Price
 As
the price varies
 Other things constant


Image of the price-consumption path
Generated: utility-maximizing behavior
•17
 Demand
curve for good1
Price
p1=2
p1=1
p1=1/2
0
a
b c
Good 1 (x 1)
The demand curve for good 1 associates the optimal quantity of good 1 with its
price, while holding income and other prices constant.
•18
Demand and Utility Functions
 Nonconvex

Optimal consumption bundle
 At

the corner of the feasible set
Maximize utility
 Spend

preferences
all income on only one good
Demand curve
 If
price > p*, quantity = 0
 If price = p*, quantity > 0
 As price decreases, quantity increases
•19
 Non
convex preferences and demand
Good 2 (x 2)
(b)
Price
(a)
B h
p1*
f
p*
e
B’ k
0
B*
Good 1 (x 1)
0
g*
Good 1 (x 1)
Indifference map.
Demand curve.
Nonconvex preferences imply optimal
Nonconvex preferences imply jumps in
consumption bundles at the corners of
the demand curve.
the feasible set—either point h or point k.
•20
Decomposing the Effects of a
Price Change
 Substitution
Effect: change in
consumption caused by a change in
relative prices
 Income Effect: change in consumption as
a result of a change in the budget set
•21
Substitution Effect
 Change
in demand due to substitution
 One
good (decreasing price)
 For another good (constant price)

The substitution effect from the decline in
price always increases demand
•22
Income Effect
 Income


effect
Decrease in price is equivalent to an
increase in real income
The income effect from the decline in price
will cause demand to
 Increase
if the good is normal
 Decrease if the good is inferior
•23
(a)
Good 2 (x 2)
Price
(b)
B
D
p’
e
p”
f
g
I1
p’
I2
p”
D’
B” Good 1 (x 1)
B’
0
f
Good 1 (x 1)
0
e
Substitution effect
Income effect
Downward-sloping demand curve
The income effect of the price change is
measured by the parallel shift of the budget
line from DD’ to BB”. The substitution effect
is measured by movement around the
indifference curve from e to g.
•24
Inferior Goods: Income and substitution effects work
on opposite directions
Good 2 (x 2)
How does the demand
curve for good 1 look
like?
B
f
D
I2
e
Substitution
effect
g
Income effect
I1
0
B’
D’
B”
Good 1 (x 1)
The substitution effect of a decline in the price of good 1 causes an increase in demand
for the good, the move from e to g. Because good 1 is an inferior good, this is partly
offset by the income effect, a decrease in demand for the good from g to f .
•25
Giffen Goods and Upward-Sloping
Demand Curves
 Giffen



good
Upper sloping demand curve
Inferior good
A price decrease
 Substitution

Increase demand
 Income

effect
effect
Decrease demand
 Dominant
effect: income effect
•26
 Giffen
good
Good 2 (x 2)
B
f
Income effect
D
Substitution
effect
e
g
I1
0
B’
D’
B”
Good 1 (x 1)
The decline in the price of good 1 causes a decline in the demand for that
good because the substitution effect (the move from e to g) is more than offset
by the income effect (the move from g to f ).
•27
Identifying normal and
Giffen goods
Type of good Substitution effect
Income effect
Normal
downward
sloping D
Opposite to price
change
The good is either superior or
inferior
but with an income effect that is
less
powerful than the substitution
effect.
Giffen
Upward
sloping D
Opposite to price
change
The good is inferior.
The income effect is more
powerful
than the substitution effect.