Income, Price and Substitution Effects And Demand Theory

Income Effect (IC)

• The effect on consumer equilibrium when income of the consumer changes while prices remain the same

Y

e1

e0

X

Price Effect (PE)

• The effect on consumer equilibrium when price of one commodity changes while price (s) of other commodity (ies) and income of the consumer remain the same

Y

e0 e1

X

Substitution Effect (SE)• The effect on consumer's equilibrium when price of a

commodity falls/rises the consumer increases/decreases the purchase of the commodity, but it is assumed that there is no increase/decrease in his/her real income, so he/she remain on the same indifference curve

Y

e0

e1

X

Demand

• Scarcity is the consequence of the mismatch between wants and ability of the economy to meet the wants

• Unlimited wants (desire) Vs Demand

• Willingness and ability generate demand

Demand

The demand for a commodity is the amount of the commodity that consumers are prepared to buy at a given price

Demand Curve

• A consumer’s demand curve represents how much of a commodity is purchased at different prices.

Demand Curve

0

2

4

6

0 20 40 60

Quntity Demanded

Pric

e

Why demand curve sloped down from left to right?

• Diminishing Marginal Utility

• Price ↓ implies Real-income ↑(income effect)

• Cheaper commodity tends to be substituted for other commodities (substitution effect)

• Price decrease leads to less urgent uses of the commodities

Law of Demand• Holding other factors constant, there is a

negative relationship between the price of a commodity and quantity demand

• LimitationsChange in taste or FashionExpectation about priceChange in incomeChange in other price (s)Discover of the substitution

Change in Quantity Demanded and Change in Demand

• Change in Quantity Demanded (Qd)

∆Qd due to ∆P

• Change in Demand (D)

∆D (shift) is due to change in factors other than price

(i.e. related good, income, preference, expectation and number of buyers )

Contraction and Extension of Demand

• Contraction and Extension are associated with Change in Quantity Demanded (Qd)

P1 a P2 b P3 c

dc Q1 Q2 Q3

Increase and Decrease in demand

• Increase (rise) and Decrease (fall) in demand are associated with Change in Demand (D)

P a b c

dc3

dc1

dc2

Q2 Q1 Q3

Elasticity of Demand

• Elasticity of demand is the measure of the responsiveness of demand to changing prices

• A small change in price may lead to a great change in quantity demanded, in such case we shall say that the demand is elastic/sensitive or responsive

• If a large change in price causes a small change in quantity demanded, then the demand is in elastic

Five Cases of Elasticity1) Perfectly elastic/ infinite elasticity

p D

Qd2) Perfectly inelastic or zero elasticity

p2

p1

Qd

3) Relatively elastic: ∆٪ Qd > ∆٪p

p

Qd

4) Relatively inelastic: ∆٪p > ∆٪ Qd

p

Qd

5) Unitary elastic: ∆٪p = ∆٪ Qd

p

Qd

Types of Elasticity• Price Elasticity (PE): it is the ratio of

percentage changes in quantity demanded in response to a percentage change in price

PE = ∆q/q ÷ ∆p/p

• Income Elasticity (PE): it shows how the demand will change when the income of the purchaser changes, the price of the commodity remaining the same

IE = ∆q/q ÷ ∆I/I

Types of Elasticity

• Cross Elasticity (CE): a change in the price of one good cause a change in the demand for another

∆qx/qx ÷ ∆Py/Py

Measurement of Elasticity• Total outlay method: in this method we

compare the total outlay of the purchaser before and after the variations in price

Unity: the total amount spent remains the same even though the price has changed

Greater than unity: with the fall in price, the total amount spent increases or the total amount spent decreases as the price rises

Less than unity: with the rise in price, the total amount spent increases or the total amount spent decreases with a fall in price

Total outlay method

S.no P Qd Total outlay

1 8 3 24

2 7 4 28

3 6 5 30

4 5 6 30

5 4 7 28

6 3 8 24

Measurement of Elasticity

• Proportional method: the elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in price changed

PE = ∆Qd/Qd ÷ ∆p/p PE = 200/400 ÷100/500 PE = 2.5

P Qd

500 400

400 600

Firm’s Behavior• In the last few lectures, we focused on the

demand side of the market; the preferences and behavior of the consumer

• Now we turn to the supply side and examine the behavior of producers

Consumer behavior Demand

market

firm’s behavior supply

Production function (PF)• Production is the result of joint efforts of the

four factors of production

• Production function is the process of transforming input into output

• Rojer. R. Millor defined PF as “it is a mathematical equation that gives a maximum quantity of output that can be produced from specific sets of inputs while technique of production are given”

• PF is the relationship between input and output

• The most efficient method of production

• Classical production function

Q = f(L)

where

Q= output

L= labor

while capital K is constant, there it is a short-run production function

Return to Factor of Production and Return to scale

• The increase in total output that results from increase in the employment of one factor of production (generally labor), assuming that the fixed input remains unchanged

Q = f(L)• When firm changes both labor and capital, the

effects on production will be analyzed with the name of “Return to Scale”

Q = f (L,K) where L is labor and K is capital,

• Total production (TP= Q): total output of a firm produced by certain number of labor

• Average product (AP): we get average product when we divide total product by the units of labor AP = TP/L = 40/5

• Marginal product (MP): the addition to total output that results from a unit increase in the employment of labor, assuming that the fixed input remains unchanged

Q L

50 10

54 11

MP = 4