PPA 723: Managerial Economics Lecture 8: Deriving Demand Curves

Managerial Economics, Lecture 8: Deriving Demand Curves Outline Deriving Demand Curves Income Elasticities of Demand Income and Substitution Effects

Managerial Economics, Lecture 8: Deriving Demand Curves Trace out the demand curve for Good B from a household-maximization diagram by holding income and the price of Good A constant and varying the price of Good B Then plot the price-quantity pairs in a new graph.

Managerial Economics, Lecture 8: Deriving Demand Curves Pulling Out Price and Quantity Combinations B , Burritos Price of Pizza Doubles per semester 25 L 1 ( p = $1) Z Price-Consumption Curve L 2 ( p = $2) Z 15 25 27 50 Z , Pizzas per semester

Managerial Economics Deriving Demand Curves (a) Indifference Curves and Budget Constraints Wine, Gallons per year 12.0 Price-consumption curve e Figure 5.1 Deriving an Individual’s Demand 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 p , $ per unit (b) Demand Curve 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

Managerial Economics, Lecture 8: Deriving Demand Curves How Income Changes Shift Demand Curves In household-maximization diagram, hold prices fixed and vary income. The increase in income causes movement along the income-consumption curve, shift of the demand curve, movement along the Engel curve.

Managerial Economics, Lecture 8: Deriving Demand Curves Income-Consumption Curve An increase in income shifts the budget line outward. An income-consumption curve plots combinations of Good A and Good B at different income levels.

Managerial Economics, Lecture 8: Deriving Demand Curves Shifts in the Demand Curve Recall that a demand curve plots price-quantity combinations for one good. A change in income changes the quantity for a good, holding price constant. So at each price, plot how quantity consumed increases with income.

Managerial Economics, Lecture 8: Deriving Demand Curves Engle Curves An Engle curve plots quantity consumed for a good (X-axis) against income (Y-axis), holding prices constant. It shows how consumption of a good changes as income changes.

Managerial Economics, Lecture 8: Deriving Demand Curves Pulling Out Income and Quantity Combinations Income Doubles B , Burritos per semester 50 L 3 ( Y = $100) Income-Consumption Curve 25 L 1 ( Y = $50) 25 50 55 100 Z , Pizzas per semester

Managerial Economics, Lecture 8: Deriving Demand Curves (a) Indifference Curves and Budget Constraints Wine, Gallons per year L 3 L 2 Income-consumption L 1 curve e 3 7.1 4.8 e 2 Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve 3 2.8 e I 1 I 2 I 1 26.7 38.2 49.1 Beer, Gallons per year (b) Demand Curves Price of beer, $ per unit E 1 E 12 2 E 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

Managerial Economics, Lecture 8: Deriving Demand Curves Income Elasticities Income elasticity: Normal good:  > 0 Inferior good:   0 Note:  is Greek xi (pronounced ks-eye).

Managerial Economics, Lecture 8: Deriving Demand Curves Income-Consumption Curves and Income Elasticities The shape of the income-consumption curve for 2 goods reveals the sign of the income elasticities. Some goods must be normal; not all goods can be inferior.

Managerial Economics, Lecture 8: Deriving Demand Curves Figure 5.3 Income-Consumption Curves and 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

Managerial Economics, Lecture 8: Deriving Demand Curves Applications to Policy Policy makers may care about the consumption of particular goods, such as health care or housing. If we know income elasticities, we can predict the extent to which people buy more of these goods when they receive a cash grant incomes in general rise.

Managerial Economics, Lecture 8: Deriving Demand Curves The Effects of a Price Change As price of Good A goes up (all else the same), there are two impacts in the quantity of Good A that is consumed: the substitution effect the income effect

Managerial Economics, Lecture 8: Deriving Demand Curves Substitution Effect Consumers substitute other, now relatively cheaper, goods for the good subject to a price increase. The direction of the substitution effect is unambiguous: It is always negative!

Managerial Economics, Lecture 8: Deriving Demand Curves Income Effect An increase in the price of Good A reduces a consumers' buying power, thereby reducing his or her real income. A change in real income is equivalent to a change in money income holding prices constant, so The direction of the income effect depends on the income elasticity of Good A

Managerial Economics, Lecture 8: Deriving Demand Curves Income and Substitution Effects price rise substitution effect income effect normal good negative inferior good positive

Managerial Economics, Lecture 8: Deriving Demand Curves Figure 5.5 Substitution and Income Effects with Normal Goods 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

Managerial Economics, Lecture 8: Deriving Demand Curves Income and Substitution Effects with an Inferior Good The substitution effect and the price change still have opposite signs. The income effect and the price change have the same signs. A Giffen good: good for which a decrease in its price causes the quantity demanded to fall (because the positive income effect is so large!)

Managerial Economics, Lecture 8: Deriving Demand Curves Figure 5.6 Giffen Good Basketball, Tickets per year L 2 L 1 e 2 L * I 2 e 1 e * I 1 Total effect Substitution effect Movies, Tickets per year Income effect

Managerial Economics, Lecture 8: Deriving Demand Curves Income and Substitution Effects: Lessons Income and substitution effects help identify consumer’s responses to changes in prices. As we will see next time, they are very useful in predicting consumer’s responses to government programs that alter prices (as many do!).