CDAE Class 10 Sept. 27 Last class: 3. Individual demand curves Today: 3. Individual demand curves Class exercise Next class: 3.Individual demand curves 4.Market demand and elasticities Quiz 3 (Chapter 3) Important date: Problem set 3: due Thursday, Oct. 4

Problem set 3 -- Due at the beginning of class on Thursday, Oct Please use graphical paper to draw graphs -- Please staple all pages together before you turn them in -- Scores on problem sets that do not meet the requirements Problems 3.1., 3.2., 3.3. and 3.4. from the textbook Two more problems: A. Suppose an individual’s demand function is Q = 20 – 0.5P (a) Calculate the consumer surplus (CS) when P = 10 (b) Calculate the change in CS when P increased from 10 to 13 B. Draw a graph and use the graph to explain why many individuals with low income prefer income subsidy over price subsidy. Then explain why many governments use price subsidies rather than income subsidies.

Take-home exercise (Tuesday, Sept. 18) While city B faces a likely shortage of electricity in the summer and a surplus of electricity in the winter, the following pricing policy has been proposed to replace the current fixed rate of $0.1 per unit: Summer (June to Sept): $0.10 per unit for the first 200 units of each month and then $0.14 for each additional unit Winter (Dec. to March): $0.10 per unit for the first 200 units of each month and then $0.08 for each additional unit Other months: $0.10 per unit How will the proposed policy affect Mr. A who consumes about 500 units per month, Mrs. B who consumes about 150 units per months, and Ms. C who consumes about 200 units per month?

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

3.4. 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)

Take-home exercise (Thursday, Sept. 27) What is a Giffen good (page 99 of the textbook)? Draw a graph to show the income and substitution effects of a Giffen good

3.4. 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.

3.4. 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

3.4. 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

3.5. Changes in the price of another good Graphical analysis: impact of a change in Px on the demand for Y (1) A fall in Px ==> An increase in both X and Y (Figure 3.3) (2) A fall in Px ==> An increase in X but a decrease in Y (Fig. 3.7)

3.5. Changes in the price of another good Substitutes and complements (1) Substitutes: Two goods such that when the price of one increases, the quantity demanded of the other good increases. (2) Complements: Two goods such that when the price of one increases, the quantity demanded of the other good decreases

3.6. Construction of individual demand curves Individual demand curve: A graphical representation of the relationship between quantity demanded (X) and its own price (P X ), holding all other factors constant An example of a linear case: P X = X or X = P X How to graph this?

3.6 Construction of individual demand curves Construction of an individual demand curve: -- Income and P Y are fixed -- Relation between X and P X -- A graphical analysis (Fig. 3.8)

Deriving an individual’s demand curve Budget 1: 12X + 35Y = 419 Budget 2: 6X + 35Y = 419 Budget 3: 4X + 35Y = 419 Deriving an individual’s demand curve Budget 1: 12X + 35Y = 419 Budget 2: 6X + 35Y = 419 Budget 3: 4X + 35Y = 419

3.6 Construction of individual demand curves Shift in individual demand curves for X (1) An increase in income If X is a normal good  IF X is an inferior good  (2) A decrease in income If X is a normal good  IF X is an inferior good  (3) An increase in the price of Y If X and Y are substitutes  If X and Y are complements  (4) A decrease in the price of Y If X and Y are substitutes  If X and Y are complements 

3.6. Construction of individual demand curves A change in quantity demanded vs. a change in demand: -- A change in quantity demanded: A movement along a demand curve. -- A change in demand: A shift of the entire demand curve from one position to another position

3.7. Consumer surplus and welfare analysis (1) What is consumer surplus (CS)? The extra value individuals receive from consuming a particular amount of a good over what they pay for that. CS = Amount of willingness to pay – actual cost (2) A graphical analysis (Fig. 3.10) (3) Change in CS (4) Applications

Class Exercise (Thursday, Sept. 27) For demand function Q = P, (a) What is the consumer surplus when the price (P) is equal to $6 per unit? (b) What is the change in consumer surplus when the price increased from $6 to $8