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

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

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

4. 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

5. 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

6. 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

7. (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

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

9. 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

10. 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

11. 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

12. 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

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

14. 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

15. 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

16. 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

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

18. Perfect complements
Burgers
fries
Lecture 13

19. 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

20. 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

21. 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