CDAE Class 10 Sept. 28 Last class: 3. Individual demand curves Today: 3. Individual demand curves Quiz 3 (Sections 3.1 – 3.4) Next class: 3.Individual demand curves Important date: Problem set 3 due Tuesday, Oct. 10

3. Individual demand curves 3.1. Basic concepts 3.2. Demand functions 3.3. Changes in income 3.4. Changes in a good’s price 3.5. Changes in the price of another good 3.6. Construction of individual demand curves 3.7. Consumer surplus 3.8. Applications

3.3. Changes in a good’s price (Px) Income, substitution & total effects: (1) Effects of a change in one price: For example: An increase in Px  sub. effect (X will decrease)  income effect (X will increase or or decrease, depending if X is normal or inferior) (2) Income effect: change in quantity demanded that is caused by the change in real income (a movement from one indifference curve to another indifference curve). (3) Substitution effect: change in quantity demanded that is caused by substitution of one good for another (a movement along an indifference curve). (4) Total effect = income effect + sub. effect

3.3. Changes in a good’s price (Px) Effects of an increase in one price (1) Total effect (2) Substitution effect & income effect (3) Total effect = Effect of a decrease in one price (1) Total effect (2) Substitution effect & income effect (3) Total effect =

Substitution and income effects of normal goods due to a decrease in Px

3.3. Changes in a good’s price Substitution & income effects for an inferior good (1) What is an inferior good? (2) A graphic analysis (Fig. 3.5)

3.3. Changes in a good’s price The lump-sum principle (1) What is the lump-sum principal? To collect the same amount of tax revenue, taxing income has smaller welfare (utility) impacts than taxing one commodity or a narrow selection of commodities. Similarly, to increase the welfare (utility) to a particular level, subsiding income will cost less than subsiding the price of one commodity or a narrow selection of commodities.

3.3. Changes in a good’s price The lump-sum principle (2) A graphic analysis (a) Effects of a tax on X: -- Budget constraint -- Utility -- Tax revenue T = t X 1 (b) Effect of a tax on income -- Budget constraint -- Utility -- Tax revenue = t X 1

3.3. Changes in a good’s price The lump-sum principle (3) Explanation of the lump-sum principle (a) A tax on X affects welfare in two ways: -- It reduces purchase power (income effect) -- It directs consumption away from the the taxed commodity (substitution effect) (b) A tax on income affects welfare in only one way (income effect) (4) The lump-sum principle and policy