1. 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!

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

3. 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!

4. 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.

5. 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.

6. 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?

7. 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.

8. 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