A primer on Consumer Choice The effects of a price and income changes: where do demand curves come from? Lecture 13

INTRODUCTION Deriving Demand Curves The price-consumption curve The income-consumption curve The Engel curve The effects of a price change Lecture 13

INTRODUCTION Can all goods be inferior? DWL from a subsidy Lecture 13

Deriving Demand Curves We know that alongside a demand curve… everything else is constant (ceteris paribus) …but the own-price of the good varies We will use our understanding of budget constraints and indifference curves to derive the demand curve Lecture 13

The price-consumption curve and the demand curve Wine, Gallons per year The price-consumption curve and the demand curve 12.0 e Price-consumption curve 3 5.2 e 2 4.3 e I 3 1 2.8 I 2 L 1 ( p = $12) I 1 L 2 ( p = $6) L 3 ( p = $4) b b b 26.7 44.5 58.9 Beer, Gallons per year (b) Demand Curve p , $ per unit b 12.0 E 1 6.0 E 2 E 4.0 3 D 1 , Demand for beer 26.7 44.5 58.9 Beer, Gallons per year Lecture 13

The income-consumption curve We also know how the budget curve changes when the income changes… We can see the implications for consumption... Lecture 13

(a) Indifference Curves and Budget Constraints Wine, Gallons per year L 3 L 2 The income-consumption curve: wine = f(beer) The demand curve: Price=f(beer) and The Engel curve: Income = f(beer) Income-consumption L 1 curve e 3 7.1 4.8 e 2 e I 3 2.8 1 I 2 I 1 26.7 38.2 49.1 Beer, Gallons per year (b) Demand Curves Price of beer, $ per unit E E E 12 1 2 3 D 3 D 2 D 1 26.7 38.2 49.1 Beer, Gallons per year (c) Engel Curve Y , Budget Engel curve for beer Y = $837 3 E * 3 Y = $628 2 E * 2 Y 1 = $419 E * 1 26.7 38.2 49.1 Beer, Gallons per year Lecture 13

Income elasticities... We can check whether a good is normal or inferior using the income-consumption curves Lecture 13

Income elasticities... Housing, Square feet per year Food inferior, housing normal ICC 1 L 2 a Food normal, housing normal ICC 2 L 1 b e c Food normal, ICC 3 housing inferior I Food, Pounds per year Lecture 13

Income elasticities... We can see now that some goods (spaghetti perhaps? :) ) can be normal AND inferior at the same time… for different levels of income Lecture 13

Income elasticities... The Engle curve: Y=f(Q)) Lecture 13 (a) Indifference Curves and Budget Constraints All other goods per year Income elasticities... Y L 3 3 Income-consumption curve Y L 2 2 e 3 Y L 1 I 3 1 e 2 e I 2 1 I 1 Hamburger per year (b) Engel Curve Y , Income Y 3 E The Engle curve: Y=f(Q)) 3 Y 2 E 2 Engel curve Y 1 E 1 Hamburger per year Lecture 13

The effects of a price change You know that every time a price changes, the quantity demanded varies because of two types of effects The substitution effect The income effect Lecture 13

The effects of a price change Wine, Gallons per year 12.0 L 2 L 1 5.5 e 2 L * I 2 e 1 e * I 1 26.7 30.6 58.9 Beer, Gallons per year Substitution Income effect effect Total effect Lecture 13

The effects of a price change In this occasion the income effect supports the substitution effect: this is a normal good Sometimes the income effect goes in the other direction (we have an inferior good) But only once in a blue moon (with pink hexagonal spots!) do we see an income effect that is strong enough to counteract the substitution effect: we have a Giffen good! Let us see! Lecture 13

Income effect is strong and positive!!! A Giffen good Fish L 2 L 1 e 2 L * I 2 e 1 e * I 1 Total effect Substitution effect Potatoes Income effect Income effect is strong and positive!!! Lecture 13

A Giffen good Now we know that the Law of Demand is an empirical one, not a theoretical axiom But still, most goods are ordinary Their demand curves slope downwards! Lecture 13

Uses of the Slutsky equation: let us analyze the extreme cases! Perfect complements Perfect Substitutes Lecture 13

Perfect complements Burgers fries Lecture 13

Perfect complements Burgers fries Therefore, you could have achieved the same total effect by just increasing income, instead of reducing the price fries Total effect = Income effect Lecture 13

Perfect substitutes Pepsis Cokes If the price of Cokes decreases … You cannot make me buy any pepsis, no matter how much income you give me. The new income constraint is already touching the original indifference curve: there is no shifting left to do! Cokes Total effect = Substitution effect (there is no income effect) Lecture 13

Perfect substitutes Pepsis Cokes If the price of Cokes increases … You cannot make me buy any Cokes!!! No matter how much income you give me. The shifting just allows me to buy more Pepsis! Still no Cokes!!! Cokes Total effect = Substitution effect (there is no income effect) Lecture 13