lecture 5: individual and market demandlfbrooks/leahweb/teaching/pppa6085/2015/le… · individual...

Admin Income Your Demand Inc. and Sub. Ef. Mkt Demand

Lecture 5:Individual and Market Demand

September 29, 2015

Overview

Course Administration

Change in Income and Changes in Consumption

Figuring Out Your Demand Curve

Income and Substitution Effects

Individual Demand to Market Demand

Course Administration

1. Return Problem Set 3

2. Problem Set 5 is posted

3. Email me to post notes if you need them before they areposted

4. Reminder: midterm October 20• Two more classes, then the midterm• Out of town for work Thursday Oct. 15; will re-schedule office

hours for Oct. 19

5. Any questions?

Ripped from the Headlines

As a reminder, next week

Afternoon

Finder Presenter

Colette Tano Lily Robin

Evening

Finder Presenter

Elizabeth Krevsky Alex SevernKevin Schoenberger Claire Viall

Concepts from Last Class

• Utility

• Indifference curves

• Budget constraint

• Utility maximization

MRSX ,Y =PX

Concepts from Last Class

• Utility

• Indifference curves

• Budget constraint

• Utility maximization

MRSX ,Y =PX

How do Changes in Income Affect Consumption?

• Income effect ≡ change in consumption due to a change inincome

• When income increases, what happens to• location of budget constraint?

shifts outward• slope of budget constraint? unchanged, since prices haven’t

changed• shape of indifference curves? nothing!

• The consumer gets more utility with more income

• When income increases, what happens to• location of budget constraint? shifts outward• slope of budget constraint?

unchanged, since prices haven’tchanged

• shape of indifference curves? nothing!

• When income increases, what happens to• location of budget constraint? shifts outward• slope of budget constraint? unchanged, since prices haven’t

changed• shape of indifference curves?

nothing!

Reminder: Some definitions

• Normal good ≡ good for which consumption increases withincome

• Inferior good ≡ good for which consumption decreases withincome

• Whether a good is normal or inferior depends on your income.Example?

Normal and Inferior Goods in PicturesFind the Inferior Good!

Income Elasticity and Types of Goods

%∆I=

∆I∗ I

• Sign of EDI for inferior goods?

EDI < 0

• Sign of EDI for normal goods? ED

I > 0• necessity goods: 0 < ED

I < 1• luxury goods: ED

• EDI = 0: Income inelastic

%∆I=

∆I∗ I

• Sign of EDI for inferior goods? ED

• Sign of EDI for normal goods?

EDI > 0

• necessity goods: 0 < EDI < 1

• luxury goods: EDI > 1

%∆I=

∆I∗ I

• necessity goods: 0 < EDI < 1

• luxury goods: EDI > 1

%∆I=

∆I∗ I

I > 0• necessity goods: 0 < ED

I < 1• luxury goods: ED

Income Expansion Path

• We want to describe thebasket of goods youconsume at each possibleincome level

• Income expansion path ≡optimal bundles at eachincome level

• Normal goods → positiveslope

• Inferior goods → negativeslope

Note: Skipping Engel curves due to time constraints!

Using Income and Utility to Find Your Demand Curve

• Recall that a demand curve shows the quantity demanded at agiven price

• In other words, what happens to consumption of X as pricechanges

• We now have the tools to figure this out for you

• We draw budget constraints and indifferences curves in Y vsX , but we need a P vs X graph for demand

X1 X2 X3

What Shifts Your Demand Curve?

• Changes in price move us along the demand curve

• Changes in tastes or income or prices of other goods may shiftthe demand curve

• How would we change the preferences in the previousexample?

Income and Substitution Effects

Any change in quantity demanded comes from at least one ofthese two sources

• Substitution effect ≡ “change in consumer’s consumptionchoices due to a change in the relative prices of goods”

• Income effect ≡ “change in consumer’s consumption choicesdue to a change in the consumer’s income”

Note that policymakers can influence both of these margins.

Price Changes and the Total Effect

Total Effect = Substitution Effect + Income EffectTotal Effect = due to price ∆ + due to income ∆

Isolating the Substitution Effect

• Change in consumption fromA (old) to B (new) due tofall in Pmeals

• Substitution effect is thechange in Q due to a changein the relative price of X andY holding utility constant

• What would you consume ifyou were at the oldhappiness (utility), butprices changed? Call this A′

• A to A′ is the substitutioneffect.

• With two normal goods,substitute toward thecheaper good

Isolating the Income Effect

• Income effect is change inconsumption due to changein purchasing power

• With normal goods, youwant more of both goods

Isolating the Income Effect

• Income effect is change inconsumption due to changein purchasing power

• With normal goods, youwant more of both goods

Walking Through Both Effects

I/PX,old

I/PX,old I/PX,new

I/PX,new

I/PX,oldtotal effect

total effect

QXI/PX,newI/PX,old

QXI/PX,newI/PX,oldsubst. effect

subst.effect

QXI/PX,newI/PX,old

QXI/PX,newI/PX,oldinc. effect

inc.effect

QXI/PX,newI/PX,old

totalincomesubstitution

QXI/PX,newI/PX,old

Substitutes, Complements and Indifference Curves

• Recall indifference curves for perfect complements

• Recall indifference curves for perfect substitutes

• Real-life indifference curves are probably usually between thesetwo extreme cases

• The less curved the indifference curves are, the moresubstitutable the goods

• Does a price change for X have a larger or smaller effect if theindifference curves are straighter? Why?

What Determines Size of Income and Substitution Effects?

Substitution Effect

• Depends on the curvature of the indifference curves

• Very curved indifference curves (closer to perfectcomplements) leads to smaller changes in response to price

• Very flat indifference curves (closer to perfect substitutes)leads to larger changes in response to price

Income Effect

• Related to the quantity of each good consumer purchasesbefore price change

• The more you spent on the good before the price change, thegreater the effect of the price change on your budget

• → Effect is largest for goods that make up the largest share ofthe budget

What Determines Size of Income and Substitution Effects?

Substitution Effect

• Depends on the curvature of the indifference curves

• Very curved indifference curves (closer to perfectcomplements) leads to smaller changes in response to price

• Very flat indifference curves (closer to perfect substitutes)leads to larger changes in response to price

Income Effect

• Related to the quantity of each good consumer purchasesbefore price change

• The more you spent on the good before the price change, thegreater the effect of the price change on your budget

• → Effect is largest for goods that make up the largest share ofthe budget

Try It Out Yourself

Monika eats chips and crackers.

• Income is $20

• Pchips = 1, Pcrackers = 2

• Her optimal choice at these prices is 16 bags of chips and 2bags of crackers

• When Pcrackers,new = 1, Monika eats 8 bags of chips and 12bags of crackers

Questions

1. Draw the budget constraint and utility curves consistent withthis description; put crackers on the x-axis

2. Find the income and substitution effects for crackers. Whichis larger?

3. Are crackers a normal or inferior good? Chips?

Monika’s Eating Habits5-12 Chapter 5 Individual and Market Demand

H. Giffen Goods1. For inferior goods, the substitution and income effects move in opposite directions.2. Thus, it is theoretically possible that if the income effect outweighed the substitution effect,

there would be a positive relationship between a good’s price and the quantity demanded by the consumer (the individual’s demand curve would be upward sloping).Definition: A Giffen good is a good for which price and quantity demanded are positively related.

5.3 additional fi gure it out

Monica eats chips and crackers. Her income is $20, and the prices of chips and crackers are $1 and $2 per bag, respectively. At these prices, she eats 16 bags of chips and two bags of crackers (point A). When the price of crackers falls to $1, Monica consumes 8 bags of chips and 12 bags of crackers (point B).

1. Why does the budget constraint rotate?

2. Label your own diagram and estimate the

income and substitution effects for crackers. Which is

larger?

Solution:

1. The price of chips has not changed, and Monica can still buy 20 bags of chips if she so chooses;

however, she can now afford twice as many crackers (20 bags).

Crackers

161412

20161282 4

BC1 BC2

Incomeeffect

Substitutioneffect

The substitution effect is measured by holding utility at the initial level; it is the movement from bundle A to bundle A′. The income effect is the movement from bundle A′ to bundle B. The income effect holds the ratio of the prices constant. For crackers, the income effect is larger than the substitution effect.

3. Crackers are a normal good because Monica purchases more when her purchasing power increases (the

income effect is positive). Chips, on the other hand, are inferior; Monica purchases fewer chips when her

purchasing power increases.

Crackers

20161282 4

BC1 BC2

Total effect

Totaleffect

Goolsbee1e_Ch05_IR.indd 5-12Goolsbee1e_Ch05_IR.indd 5-12 5/21/13 5:24 PM5/21/13 5:24 PM

5-12 Chapter 5 Individual and Market Demand

H. Giffen Goods1. For inferior goods, the substitution and income effects move in opposite directions.2. Thus, it is theoretically possible that if the income effect outweighed the substitution effect,

there would be a positive relationship between a good’s price and the quantity demanded by the consumer (the individual’s demand curve would be upward sloping).Definition: A Giffen good is a good for which price and quantity demanded are positively related.

5.3 additional fi gure it out

Monica eats chips and crackers. Her income is $20, and the prices of chips and crackers are $1 and $2 per bag, respectively. At these prices, she eats 16 bags of chips and two bags of crackers (point A). When the price of crackers falls to $1, Monica consumes 8 bags of chips and 12 bags of crackers (point B).

1. Why does the budget constraint rotate?

2. Label your own diagram and estimate the

income and substitution effects for crackers. Which is

larger?

Solution:

1. The price of chips has not changed, and Monica can still buy 20 bags of chips if she so chooses;

however, she can now afford twice as many crackers (20 bags).

Crackers

161412

20161282 4

BC1 BC2

Incomeeffect

Substitutioneffect

The substitution effect is measured by holding utility at the initial level; it is the movement from bundle A to bundle A′. The income effect is the movement from bundle A′ to bundle B. The income effect holds the ratio of the prices constant. For crackers, the income effect is larger than the substitution effect.

3. Crackers are a normal good because Monica purchases more when her purchasing power increases (the

income effect is positive). Chips, on the other hand, are inferior; Monica purchases fewer chips when her

purchasing power increases.

Crackers

20161282 4

BC1 BC2

Total effect

Totaleffect

Goolsbee1e_Ch05_IR.indd 5-12Goolsbee1e_Ch05_IR.indd 5-12 5/21/13 5:24 PM5/21/13 5:24 PM

Finally, Getting to Market Demand!

• Market demand is the sum of all individual demands

• Add individual demands horizontally

• For any price, add the quantities

Adding Horizontally

Using Algebra To Do This

Suppose we have two demand curves

• QJoe = 5− 0.05P

• QJack = 13− 0.25P

This is a piece-wise linear function. What are the pieces?

• At P > $52, Jack doesn’t want any more

• At P > $100, Joe doesn’t want any more

Using Algebra To Do This

Suppose we have two demand curves

• QJoe = 5− 0.05P

• QJack = 13− 0.25P

This is a piece-wise linear function. What are the pieces?

• At P > $52, Jack doesn’t want any more

• At P > $100, Joe doesn’t want any more

In PicturesJoe’s Demand

In PicturesJack’s Demand

The Algebra of Demand Curve Addition

• Note that no one wants to pay more than $100

• The maximum total quantity demanded is Q = 18

We write this as

{QJoe + QJack = 18− 0.3P if 0 < P ≤ 52

QJoe = 5− 0.05P if 52 < P ≤ 100

The Algebra of Demand Curve Addition

• Note that no one wants to pay more than $100

• The maximum total quantity demanded is Q = 18

We write this as

{QJoe + QJack = 18− 0.3P if 0 < P ≤ 52

QJoe = 5− 0.05P if 52 < P ≤ 100

Market Demand in Pictures

blue = total market demand

curve kinks at P=52, Q=2.4

Just in Case We Have Time: Adding Demand Curves

In a very small town, only Jim and Alice want gasoline. Jim’sdemand is QJ = 15− 3P and Alice’s is QA = 30− 5P.

1. Find the equation for the market demand for gas

2. Draw the demand curve in a chart

Recap of Today

• Changes in Income and Utility Maximization

• Changes in Prices and Utility Maximization

• Income and Substitution Effects

• Market Demand

Next Class

• Problem Set 4

• Producers! GLS, Chapter 6

lecture 5: individual and market demandlfbrooks/leahweb/teaching/pppa6085/2015/le… · individual...

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