Where Do Demand Curves Come From? Prices, Preferences & Slutsky! The Birds & The Bees of Micro Theory Focus is on neoclassic economic theory. Identify the critical assumptions that limit the model (by necessity) but also limit the questions that can be asked and the answers that can conform to the theory. Where Do Demand Curves Come From? Prices, Preferences & Slutsky!

Two Hands Clapping!?! Preferences: Prices ► Complete ► Transitive ► Convex ► More UTILITY is better Prices ► Substitution effect ► Income Effect

Indifference Curves & Utility Functions Budget constraint Utility curves There are really THREE things going on here – two goods and utility – three dimensional (N-dimensional with N goods!) Feasible budget is a plane, binding budget constraint is the top line of the plane. Be careful – ratio changes based on what measure you use for MRS. Opportunity cost notion – marginal utility of X is the change (what you’re willing to give up) in Y. Different notation Same meaning!

Pay attention to what is on the X and Y axes! So Where DO Demand Curves Come From? composite good quantity Price What is the price of shelter at this budget constraint? KEY: Pay attention to what is on the X and Y axes! At this price, what is the optimal quantity of shelter? What’s changing in the top graph? – only the price of X Hammer skill of looking at what is on the X and Y axis of a graph. This shows the CHANGE IN QUANTITY DEMANDED for a given change in PRICE Test yourself: Ask the same two questions for the other points on the indifference and demand curves.

What is Elasticity? Key things to remember about elasticity: quantity Price Point elasticity Change Mid-point Arc elasticity Key things to remember about elasticity: Elasticity is NOT CONSTANT along the demand curve. If quantity does not change, demand is perfectly INELASTIC. If price does not change, demand is perfectly ELASTIC. (mathematically elasticity is undefined) Percent change in quantity for a percent change in price If quantity does not change, ΔQ = 0 and elasticity = 0 If price does not change, ΔP = 0 and elasticity is not defined Arc is used when there is no known functional form for demand – can’t use calculus to get instantaneous change at a point. Emphasize that the only thing that causes a shift in the QUANTITY DEMANDED is PRICE. Everything else is a shift in DEMAND – the whole line. Test yourself: Draw demand curves that are elastic and inelastic.

What would cause a shift in Demand? A change in income Income elasticity of demand Examples of inferior goods: Raman noodles, cheap cars/bus transportation, check cashers, rent-to-own For necessities, price increases lead to increased share of budget spent on the item. For luxuries, price increases lead to decreased share of budget spent on the item. Giffen goods mean price increases lead to increased quantity and increased share of budget (potatoes during the famine) Inferior good Normal good Necessity Luxury Test yourself: What are some examples of each type of good?

Slutsky & Elasticity Re-write the way we have written elasticities with x = Q for quantity of X Multiply both sides by P/Q, the last term by M/M and re-arrange M and Q NOTE: You will need to draw demand curves and write your justification of HOW you draw them for your end-of-semester market analysis essay! Own price elasticity = compensated price elasticity – share of income * income elasticity Test yourself: Pick a product/service and draw the demand as a function of both the substitution and income effects.

Yikes! That was a lot of stuff! The key relationship: The intuition: We consume to the point where the marginal cost (price) = the marginal benefit Where Do Demand Curves Come From? Preferences & Prices, Substitution & Income Effects