Econ 311

Demand
 Applications of micro theory
• If you remember from Day 1:
– Even though this stuff seems abstract, demand
modeling is done by firms, non-profits and the
government in almost every industry

– “If we raise the price of our product by Z%, what

will happen to our sales?”
 Applications of micro theory
• The models that people use to estimate
demand responses are derived from utility
maximization.

• In other words, Kraft sets up a utility function

that they think represents preferences for Mac
& Cheese and related goods.
– They derive and estimate the associated demand
function
 Demand functions
• Until now, we’ve only solved utility
maximization problems with the goal of
finding the level of demand.
– In other words, our answers have been numbers.
 Demand functions
• We need to start solving them without
specifying prices or income.
– This way, we can analyze how demand responds
when prices and income change.

– The math is the same, the algebra is just a little

uglier.
 Demand functions
• Cobb-Douglas:
 Demand functions
• Cobb-Douglas:
 Demand functions
• Cobb-Douglas:
 Demand functions
• Cobb-Douglas:
 Demand functions
• Cobb-Douglas:
 Demand functions
• Cobb-Douglas: these are general solutions
 Demand functions
• When X* and Y* are formulas, they are now
called demand functions.

• These formulas describe the demand

functions for all Cobb-Douglas utility
functions.
– If you remember them, you can use them as a
shortcut or to check your work (unless I tell you
you can’t)
 Demand functions
• In general, the demand for X and Y are
functions of three things:
– Px, Py and M
– X* = f(Px, Py, M)
– Y* = f(Px, Py, M)

• With Cobb-Douglas, it just happens that Py

doesn’t appear in X* and Px doesn’t appear in
Y*. This is not always true.
 Demand functions
• We’re interested in how demand responds to
all three of those arguments.

• We’ll start with income: how does your

consumption of X* and Y* change when your
income changes?
 Demand functions
• Important note for the rest of the lecture:
– When we do math that starts with the utility
function, we’ll always use one of our friendly 4
utility functions

– When we play around with graphs, we’re going to

consider all sorts of cases that don’t correspond to
those utility function.
• Don’t worry, there’s no new math, it’s just conceptual.
 Demand functions
• Important note for the rest of the lecture:
– Basically, we will get used to freely drawing
standard indifference curves (the nice, curved
ones) wherever we need to draw them in order to
make the point we want to make.
 Income changes
• Let’s start by graphing a standard solution to a
utility maximization problem and then seeing
what happens when income (M) increases.
Income changes
Income changes
 Income changes
• When income goes up, I can now get to a
higher indifference curve and end up better
off.

• Assuming both goods are normal goods (this

is a definition), I will respond to the income
increase by consuming more of both X and Y.
Income changes
 Income changes
• Did it have to be the case that consumption of
both X and Y went up in response to the
increase in income?

• No. In addition to normal goods, we have

inferior goods, goods that you consume less
of when your income goes up.
 Income changes
• Throwing out examples of inferior goods can
be awkward:

– Different people have different preferences, so to

say “I’d only consume that if I had no money” is
tough to say in general (and potentially rude).
 Income changes
• Throwing out examples of inferior goods can
be awkward:
– I’ll choose what I hope is an uncontroversial and
minimally offensive example: Natural Lite beer

– I drank it when I was in college and had limited

resources.
– I haven’t had one since the day I graduated.
 Income changes
• Graphically, let’s start from a similar place.
We’re at a standard solution and then income
goes up.
Income changes
 Income changes
• Our goal is to draw the new optimal (utility-
maximizing bundle) such that Y is an inferior
good.

– The increase in income must lead to a decrease in

Y*, in other words.
Income changes
Income changes
 Income changes
• Note: when you experience an income
decrease instead of an income increase, the
definitions reverse.

– If your income goes down and your consumption

of X goes down, X is normal.
– If your income goes down and your consumption
of Y goes up, Y is inferior.
 Income changes
• Can both X and Y be inferior goods?

– In other words, when your income goes up, can

you buy less of both goods?

– Why or why not?

 Income changes
• You can’t because of the budget constraint.

– If your income goes up and you decrease the

amount of X you buy, that means there’s a lot of
money left over to increase your Y consumption.

– In fact, if increasing your income has no effect on

the amount of X you buy, you still have to increase
consumption of Y.
 Engel curves
• We can graph the function that relates income
to demand for a good (holding prices
constant).
– Let’s start with a graph with a bunch of income
levels and the associated Y* consumption levels.

– Then, we can graph the relationship between M

and Y* with M on the vertical axis and Y* on the
horizontal axis. This is an Engel Curve.
Engel curves
Engel curves
 Engel curves
• The sign of the slope of an Engel curve tells us
if a good is normal or inferior.

– A positive slope means that when income goes

up, Y* goes up and Y is normal.
– A negative slope mean that when income goes up,
Y* goes down and is inferior.
 Engel curves
• This showcases an important fact about
inferior goods:

– Can a good be inferior over all income levels?

– In other words, can it be the case that no matter

what my current income is, an increase in income
will decrease my consumption of a good?
 Engel curves
• No. This is impossible.

• Let’s draw an Engel curve with a negative

slope and see why:

– Hint: remember that when M = 0, it must be the

case that Y* = 0.
Engel curves
Engel curves
 Engel curves
• Even a good that is typically inferior, or we
could say “inferior over common income
levels” must be a normal good over low
enough levels of income.

• In the context of Natural Lite:

– When in college, the more $ you have, the more
you buy (normal), but once you get a job, you
never buy it (inferior)
 Engel curves
• Mathematically, Engel curves are graphs of the
demand function
– X* = f(Px, Py, M)

• That hold prices fixed and reverse the axes.

• Take our Cobb-Douglas example:

Engel curves
Engel curves
 Engel curves
• So Cobb-Douglas Engel curves showcase the
fact that all CD goods are normal goods over
at all income levels.

• We can determine this mathematically as well:

– X* = f(Px, Py, M)
– Take the derivative with respect to M
Engel curves
 Engel curves
• Let’s think through Engel curves for PS utility.

• Imagine that currently MRS > Price Ratio

– This means….?
 Engel curves
• Let’s think through Engel curves for PS utility.

• Imagine that currently MRS > Price Ratio

– So only X is being consumed
• X* = M/Px
• Y* = 0
 Engel curves
• Let’s think through Engel curves for PS utility.

• When M goes up or down, this has no effect

on the price ratio.
– Since the MRS is constant as well, income changes
have no effect on the decision being made
– So Y* will always be 0
• Engel curve is the vertical axis
 Engel curves
• Let’s think through Engel curves for PS utility.

• When M goes up or down, this has no effect

on the price ratio.

– X* will always be the maximum possible X

– So the demand curve for X is X* = M/Px
– Therefore the Engel curve is M = Px X*
• Straight line with slope Px
 Income-Offer Curves
• It’s useful to be able to graph both the Engel
curve for a specific demand function and the
effect of income changes on the optimal
bundle in (x,y) space.

• PS example:
Income-Offer Curves
 Income-Offer Curves
• There’s a specific term given to this graph:
– The book calls it the “Income Offer Curve”
– A lot of people also call it the “Income-
Consumption Locus”

• In general, the curve represents the

relationship between Y* and X* that holds at
all income levels
 Income-Offer Curves
• In general, the curve represents the
relationship between Y* and X* that holds at
all income levels

– For PS, the income offer curve is either Y* = 0 or

X* = 0
 Income-Offer Curves
• In general, the curve represents the
relationship between Y* and X* that holds at
all income levels

– Any ideas for what the offer curve is for PC?

 Income-Offer Curves
• In general, the curve represents the
relationship between Y* and X* that holds at
all income levels

– Any ideas for what the offer curve is for PC?

• The no-waste condition.
• Regardless of income, the no-waste condition always
relates Y* to X*
 Income-Offer Curves
• In general, the curve represents the
relationship between Y* and X* that holds at
all income levels

– Any ideas for what the offer curve is for CD/QL?

 Income-Offer Curves
• In general, the curve represents the
relationship between Y* and X* that holds at
all income levels

– Any ideas for what the offer curve is for CD/QL?

• The optimality condition: MRS = price ratio
• Regardless of income, X* and Y* are related via the
optimality condtion
 Income-Offer Curves
• So in summary, we’ve got two graphical
techniques for measuring the effects of
income changes:

– Engel Curves (one good at a time) and Income-

Offer Curves (both good at the same time)
 Income-Offer Curves
• We also discussed how the mathematical
properties of the demand function translate
into the Engel curve:
– The Engel curve is a version of the demand
function with prices held constant and the axes
reversed
– The partial derivative of the demand function with
respect to M reveals the sign of the slope .
• Based on the sign we can classify normal vs. inferior
 Elasticity
• We’re going to talk about one more way of
measuring the response of demand to
income.

• Motivation for elasticity:

– Imagine you have a demand function for pints of
beer.
 Elasticity
• Motivation for elasticity:
– Imagine you have a demand function for pints of
beer in the U.S.
• The partial derivative of X* with respect to M tells you
how many more pints I buy when my income goes up
by $1
 Elasticity
• Motivation for elasticity:
– Now, you’ve got to compare the income-
responsiveness of beer in the U.S. to Canada.

– You get data from Canada and they give you a

demand function for liters of beer.
• The partial derivative of X* with respect to M tells you
how many more liters I buy when my income goes up
by $1
 Elasticity
• Even if beer consumers in both countries have
the same utility function, the fact that their
consumption is measured in different units
will give you different measures of
responsiveness.
 Elasticity
• Since you can easily convert liters into pints,
this isn’t a big problem.

• But… Imagine you’re a government trying to

figure out whether consumption of oil or
natural gas will respond more heavily to
changes in an income tax.
 Elasticity
• The demand for oil is measured in gallons and
the demand for natural gas is measured in
cubic feet.
– The partial derivatives are measured in Gallons-
per-dollar and cubic-feet-per-dollar respectively.

• How can you compare the two things?

 Elasticity
• Elasticity is a unit-free measurement of how
responsive demand is to income (and other
things that we’ll talk about later).

• In other words, it’s a way of adjusting the

partial derivative of X* with respect to M that
allows you to make comparisons between any
goods regardless of how they’re measured.
 Elasticity
• Formula:
 Elasticity
• In words:
– The elasticity of X with respect to M is the partial
derivative of X with respect to M, multiplied by
the current ratio of M to X

• This is a totally general definition

mathematically:
– The elasticity of Y with respect to Z is …
Elasticity
Elasticity
 Elasticity
• So there are 3 steps to calculating an
elasticity:
– 1. Take the partial derivative
– 2. Multiply that partial derivative by the ratio of
the input variable to the response variable
– 3. Substitute the original equation in for the
response variable and simplify
 Elasticity
• Why is this a unit-free measurement that can
be compared across goods?
– Math with units:
 Elasticity
• Great, elasticity has no units. What does it
mean?
– It represents the proportion with which the
response variable is affected by the input variable.
Elasticity
Elasticity
Elasticity
Elasticity
 Elasticity
• Elasticity tells you how to translate a
proportional change in X into a proportional
change in Y.

• It can be positive, negative or zero

– We’ve only considered the elasticity of demand
with respect to income so far:
• Normal goods have positive elasticities
• Inferior goods have negative elasticities
 Elasticity
• We have terms to describe how responsive
things are in terms of elasticity:

– If the absolute value of an elasticity is greater than

1, we say that there is an “elastic” response.
– If the absolute value of an elasticity is less than 1,
we say that there in an “inelastic” response.
– If the absolute value of an elasticity is equal to 1,
we say that the response is “unit elastic”
 Elasticity
• We have terms to describe how responsive
things are in terms of elasticity:

– If the elasticity is exactly equal to zero, we call this

“perfectly inelastic”

– If the elasticity is infinite, we call this “perfectly

elastic”
 Elasticity
• In our example earlier, we calculated the
elasticity of demand with respect to income
for a perfect-substitutes good.

• We calculated an elasticity of 1:
– So when you have PS utility, the elasticity of
demand with respect to income is unit elastic (for
the good that you consume).
Elasticity
Elasticity
Elasticity
 Elasticity
• The elasticity is allowed to depend on the
input variable (M in the current case)

• The elasticity never depends on the response

variable (X* in the current case)
 Income changes
• The last thing we’ll do for analyzing the
response to income changes is to do a big
example that covers all the concepts.
 Income changes
• Given U = 12 ln(X) + Y:
– Find X* and Y*
– Draw a graph in the (x,y) plane with 3 ICs and fill in
the income-offer curve.
– Draw the Engel curves for both X* and Y*
– Calculate the derivatives of X* and Y* with respect
to income and classify them
– Calculate the elasticities of demand with respect
to income and classify them
Income changes
Income changes
Income changes
Income changes
Income changes
Income changes
Income changes
Income changes
Income changes
 Price changes
• Own price changes are the most important
types of changes that we consider.
– In other words, this is the stuff people in the real
world most want to know about.

• When you hear the term “demand curve” or

“elasticity” without specifying whether it’s
about price or income or something else, the
default is own price
 Price changes
• There will be analogous concepts for price to
all the concepts we learned for income.
– The income offer curve becomes the “price offer
curve “
– The Engel curve becomes the “demand curve”
– Normal and inferior goods become “ordinary” and
“Giffen” goods
– Elasticity concept stays the same
 Price changes
• Note that the generic term “demand curve” is
our price version of the Engel curve.
– This is exactly the demand curve that will help us
construct a measure of market demand at the end
of the unit on consumer choice
 Price changes
• Before we start examining some price
changes, I’ll note that price changes, in
general, are more complicated than income
changes.

• So we’ll go through each type of utility

function here, unlike in the income section.
 Price changes
• Let’s start with a standard IC example:
Price changes
 Price changes
• Let’s draw what happens when X gets cheaper.

– The budget will get flatter with a bigger x-

intercept

– Let’s assume that X is an ordinary good: when it’s

price goes down, consumption goes up
Price changes
 Price changes
• Did it need to be the case that we purchased
more X when it got cheaper?

– No. If the consumption of X and the price of X

move in the same direction (cheaper, buy less or
more expensive, buy more) we have a Giffen good
Price changes
Price changes
Price changes
 Price changes
• The price offer curve follows a similar logic to
the income offer curve:
– Holding income (M) and the price of the other
good fixed (Px), the price offer curve connects all
of the optimal bundles for all the possible levels of
own price (Py)
Price changes
Price changes
 Price changes
• Unlike the income offer curve, the price offer
curve does not usually go to the origin point.
– Remember: as income falls to zero, the optimal
bundle is forced towards (0,0)

– With non-PC utility at least, where does is the

optimal bundle forced towards as Py gets infinitely
expensive?
 Price changes
• Unlike the income offer curve, the price offer
curve does not usually go to the origin point.
– Remember: as income falls to zero, the optimal
bundle is forced towards (0,0)

– With non-PC utility at least, where does is the

optimal bundle forced towards as Py gets infinitely
expensive?
• The point (M/Px, 0): buy no Y
Price changes
 Price changes
• If we isolate just the relationship between Py
and Y*, that information is used to construct
the demand curve.
– Note that as Py gets big, Y* approaches zero
• This will show up on the graph (except with PC)

– The demand curve is like the Engel curve for price:

• Py on the vertical axis and Y* on the horizontal axis
Price changes
Price changes
Price changes
 Price changes
• Slope of the demand curve
– Ordinary demand curves have negative slopes
(higher price, less consumption and vice versa)

– Giffen demand curves have positive slopes (higher

price, more consumption and vice versa)
 Price changes
• Can a good always be Giffen?
– In other words, regardless of what Py currently is,
can the response to a price increase always be to
increase the consumption of Y?
 Price changes
• Can a good always be Giffen?
– In other words, regardless of what Py currently is,
can the response to a price increase always be to
increase the consumption of Y?

– No: the budget prevents this from happening.

Imagine that you’re consuming only Y. When its
price goes up you have to consume less.
 Price changes
• Can a good always be Giffen?
– Even if you aren’t consuming only Y, if Y is Giffen
over a large range of prices, when the price gets
high enough, you’ll get to a point where you are
consuming a lot of Y.

– When Py goes up again, you simply cannot afford

to consume more of it
 Price changes
• Can a good always be Giffen?
– So even if the slope is positive over some region of
prices, once the price gets high enough, the slope
will revert to being negative.
Price changes
Price changes
 Price changes
• Corresponding mathematical concept
– Recall: X* = f(Px, Py, M) and Y* = f(Px, Py, M)

• The demand curve for X is X* = f(Px) where M

and Py and held fixed and the axes are
reversed.

• Take our general Cobb-Douglas example:

Price changes
 Price changes
• What is this graphically?
– Imagine for the moment:

– Y* = ½ corresponds to Py = 2
– Y* = 1 corresponds to Py = 1
– Y* = 2 corresponds to Py = ½
Price changes
 Price changes
• So the standard demand curve is downward
sloping with some convexity (just like a
standard IC)
– The constant that we ignored just moves this
shape around

• The slope corresponds to the derivative of the

demand function with respect to own price.
Price changes
 Price changes
• The concept of elasticity is identical for price
as it was for income.

• Terminology reminder: if someone just says

“elasticity of demand” they are referring to
the elasticity of X* with respect to Px (or Y*
with respect to Py).
Price changes
Price changes
 Price changes
• With CD and QL utility, these concepts are a
straightforward mirror of the income
concepts.

• With PS and PC utility, things are different.

 Price changes
• With PS utility, the effect of changing price on
consumption is strongly dependent on one big
factor.

• Remember what optimal bundles look like for

PS utility. What factor will determine how
consumption responds to price?
 Price changes
• Remember what optimal bundles look like for
PS utility. What factor will determine how
consumption responds to price?

– Are you currently consuming any of the good that

experiences a price change?
 Price changes
• I’m walking down the beer aisle at Safeway
and I notice that Natural Lite is on sale for
$11.99 per case (down from a usual $14.99).

• What effect does this have on my

consumption?
 Price changes
• I’m walking down the beer aisle at Safeway
and I notice that Natural Lite is on sale for
$11.99 per case (down from a usual $14.99).

• What effect does this have on my

consumption?
– None! For me Natural Lite and Ninkasi are perfect
substitutes and currently I’m choosing to only
consume Ninkasi.
 Price changes
• So price changes in the context of PS only
matter in two circumstances:
1. You are currently consuming the good that has a
change in price

2. The price of the good you are NOT consuming

drops so substantially that it changes which of
the two goods you consume.
 Price changes
• Example:
– Natural Lite is currently $0.40 per beer (X)
– Ninkasi is currently $1.60 per beer (Y)

– Imagine that I’m willing to trade 6 Natural Lites for

1 Ninkasi (MRS = 1/6)

– 1/6 < 1/4, so I’m consuming only Ninkasi (X* = 0)

• M = 16 means that Y* = 10
 Price changes
• Example:
– Imagine the price of Ninkasi goes up to $2 per
beer

– Will this affect my optimal bundle?

 Price changes
• Example:
– Imagine the price of Ninkasi goes up to $2 per
beer

– Will this affect my optimal bundle?

• Yes: I’m currently consuming Ninkasi and its price
changes.
• Consumption of Ninkasi changes
• Consumption of Natural Lite only changes if the MRS –
price ratio relationship is flipped
 Price changes
• Example:
– Imagine the price of Ninkasi goes up to $2 per
beer

– New price ratio is 0.40/2 = 1/5

– MRS = 1/6 < 1/5

– So I’m still consuming only Ninkasi (X* = 0), but

the amount I can consume goes down (Y* = 8)
 Price changes
• Example:
– Imagine the price of Ninkasi goes up again to
$2.80 per beer.

– New price ratio is 0.40/2.80 = 1/7

– MRS = 1/6 > 1/7

– This price is high enough to flip my preference

• No Ninkasi (Y* = 0) and all Natural Lite (Y* = 40)
 Price changes
• These relationship are going to produce some
odd looking price offer curves and demand
curves.
– There will be regions of perfect elasticity and
regions of perfect inelasticity in the demand
curves
Price changes
Price changes
Price changes
 Price changes
• The vertical region on the graph indicates
perfectly inelastic demand for X.

– That’s where X* = 0
– So the partial derivative of X* with respect to Px is
zero. That forces the elasticity to be zero also.
– In that region, small changes to the price have no
effect on X*.
 Price changes
• The horizontal region on the graph indicates
perfectly elastic demand for X.

– That’s MRS = price ratio

– A tiny increase in Px makes X* = 0
– A tiny decrease in Px makes X* = 8
– Because of this discontinuity in the demand
function, we say demand is infinitely responsive to
price, or that X is perfectly elastic
 Price changes
• When Px is less than 3, the demand curve
looks quite normal.
 Price changes
• Price offer curves for PS utility are also going
to feature big, sudden changes.
– Assume you are currently consuming only Y
(meaning MRS < Px/Py).
– As Py increases:
• Initially X* remains equal to 0 and Y* goes down as
M/Py goes down
• Eventually, MRS = Px/Py and any point on the budget is
optimal
• Once MRS > Px/Py, Y* = 0 and X* = M/Px and there is
no more effect of Py on consumption at all
 Price changes
• Graphically:
– The price-offer curve will be the Y-axis when Y is
the good being consumed (MRS < Px/Py)
– When MRS = Px/Py, the price-offer curve covers
the entire budget
– When MRS > Px/Py, only X is consumed and the
price-offer curve is stuck at (M/Px,0)
Price changes
Price changes
 Price changes
• Our last order of business on price changes is
to talk about PC utility.

• It turns out that while they behave differently,

they are very simple.
– Recall that prices have no effect on the no-waste
condition (homework!)
Price changes
 Price changes
• All optimal bundles are on the no-waste line

• As a price changes, the intersection between

the budget and the no-waste function just
moves up and down the no-waste line

• Price changes are equivalent to income

changes with PC utility
 Price changes
• Price changes are equivalent to income
changes with PC utility

• So the price-offer curve is the no-waste line

and is thus the same as the income offer
curve.
 Price changes
Let’s do the math behind the demand curve.
Price changes
Price changes
Price changes
Price changes
 Price changes
• The last thing we’re going to talk about with
price changes is the Slutsky Decomposition.

• This is a way of understanding the effects of

price changes on demand more closely.
 Price changes
• Basic idea: when the price of a good goes up,
this has two effects on your decision making:

– That good becomes relatively more expensive

 Price changes
• Basic idea: when the price of a good goes up,
this has two effects on your decision making:

– That good becomes relatively more expensive

– In a sense, you are now poorer. Because price
went up and your income stayed the same, you
have less overall purchasing power.
 Price changes
• We want to be able to look at the effect of a
price change on your demand and figure out
how much of it was:

– “relative price effect” or “substitution effect”

– “income effect”
 Price changes
• Imagine that you’re currently consuming pizza
and beer.

– An increase in the price of pizza:

• Makes beer relatively more attractive and pizza less
attractive
• So you buy less pizza
 Price changes
• Imagine that you’re currently consuming pizza
and beer.

– An increase in the price of pizza:

• Makes your income go down
• You buy less pizza if pizza is normal
• You buy more pizza if pizza is inferior
 Price changes
• Imagine that you’re currently consuming pizza
and beer.

– An increase in the price of pizza:

• The total effect of the price change is the sum of the
two effects, the income and substitution effects.
• As usual, this is easiest to understand graphically
Price changes
 Price changes
• That graph shows the initial budget and the
final budget.

– Moving from X*1 to X*2 is the total effect of the

price increase on demand for X
 Price changes
• That graph shows the initial budget and the
final budget.

– Moving from X*1 to X*2 is the total effect of the

price increase on demand for X

– Our goal now is to figure out how much of that

came from the substitution effect and how much
came from the income effect
 Price changes
• Let’s take these one-by-one: Substitution

– We want to think about the effect of changing the

relative prices only, without at all considering the
effects of becoming poorer

– What, graphically, represents the relative prices?

 Price changes
• Let’s take these one-by-one: Substitution

– We want to think about the effect of changing the

relative prices only, without at all considering the
effects of becoming poorer

– What, graphically, represents the relative prices?

• The slope of the budget constraint
 Price changes
• Let’s take these one-by-one: Substitution

– So, if we want to consider the effect of changing

the relative prices without changing anything else,
let’s change the slope of the budget constraint.

– BUT: let’s not make you any less happy

 Price changes
• Let’s take these one-by-one: Substitution

– This is the substitution effect: the effect of

changing the slope of the budget line without
changing which indifference curve you’re on.
Price changes
 Price changes
• In the graph, the substitution effect is the
movement from X*1 to Xs.

• Important note: the substitution effect will

always be negative!
 Price changes
• In the graph, the substitution effect is the
movement from X*1 to Xs.

• Important note: the substitution effect will

always be negative!
– When Px goes up, the substitution effect always
says that you should consume less X
 Price changes
• Important note: the substitution effect will
always be negative!
– When Px goes up, the substitution effect always
says that you should consume less X
• This is because:
– when you increase the slope of the budget, the
new optimum requires a larger MRS (steeper IC)
– Convex indifference curves get steeper when you
move up and left (so X goes down)
 Price changes
• Think of the substitution effect as what
happens when you rotate the budget line
along the curved surface of the indifference
curve

– When Px/Py goes up, it gets steeper and rolls up

and left
– When Px/Py goes down, it gets flatter and rolls
down and right
 Price changes
• The income effect is what’s left over: the
movement from Xs to X*2
Price changes
 Price changes
• The income effect is what’s left over: the
movement from Xs to X*2

– Note that the budget line for X*2 and Xs both

have the same slope.
 Price changes
• The income effect is what’s left over: the
movement from Xs to X*2

– Note that the budget line for X*2 and Xs both

have the same slope.
• Moving from Xs to the X*2 is just like experiencing a
decrease in income, holding prices constant
• That’s why it’s called the income effect
 Price changes
• So, looking at our graph, we’d say that the
total effect of the increase in the price of X is
driven mostly by the substitution effect.

• The income effect pushes in the same

direction as the substitution effect because X
is normal
– The income decrease results in a lower demand
 Price changes
• Let’s try a similar graph for a price decrease to
Y.

• Let’s assume that Y is an inferior good.

– Also, to make things easier, I’m going to draw the

substitution effect first.
Price changes
 Price changes
• So we’ve got our original budget and the
outcome there and the new budget but no
outcome yet.

– When Py goes down, the budget gets steeper.

– Let’s add a budget that achieves the same utility
as the original budget but has the same slope as
the new budget.
Price changes
 Price changes
• That movement along the original indifference
curve is the substitution effect.

• Since the substitution effect is always

negative: a price decrease to Y means an
increase in consumption of Y
– Let label the outcomes that show this
Price changes
 Price changes
• So Y*1 has increased to Ys
– Substitution effect always moves X and Y in
opposite directions

• Now we want to show the income effect:

– The movement from Ys to Y*2 is the income effect
 Price changes
• Since the price of Y decreased, our income
effect represents an increase in income.

– If Y is an inferior good, then the move from Ys to

Y*2 must be negative.

– Let’s add the final point such that Y*2 is less than
Ys
Price changes
 Price changes
• The total effect is a small decrease in the
consumption of Y
– Y is a Giffen good

• That total effect was a combination of:

– A substitution effect from Y*1 to Ys that increased
consumption of Y
 Price changes
• The total effect is a small decrease in the
consumption of Y
– Y is a Giffen good

• That total effect was a combination of:

– An income effect from Ys to Y*2 that decreased
consumption of Y enough to outweigh the
substitution effect
Price changes
 Price changes
• This teaches us a couple things:

– Giffen goods MUST also be inferior goods

– A good is Giffen if the total effect of the price

decrease is negative
 Price changes
• Giffen goods MUST also be inferior goods

– A good is Giffen if the total effect of the price

decrease is negative
• Since the substitution effect always says that a price
decrease increases consumption:

• The only way for a good to be Giffen is if a strong,

inferior Income effect outweighs the substitution effect
 Price changes
• Inferior goods DO NOT have to be Giffen
goods.

– We could’ve drawn a total effect of the price

decrease that was positive even if the income
effect worked against the substitution effect
Price changes
 Price changes
• In summary:

– A good is ordinary if the income effect and

substitution effect go in the same direction
• This happens when the good is normal
 Price changes
• In summary:

– A good is ordinary if the income effect and

substitution effect go in the same direction
• This happens when the good is normal

– A good is also ordinary if the effects go in opposite

directions, but the substituion effect IS BIGGER
than the income effect
• This happens when the good is inferior
 Price changes
• In summary:

– A good is Giffen if the effects go in opposite

directions, but the substituion effect IS SMALLER
than the income effect
• This happens when the good is inferior
 Math of Price Changes
• Our standard tool for measuring how demand
responds to price is a derivative:
 Math of Price Changes
• The slutsky decomposition tells us that the
effect of price changes on demand is
composed of two parts:

– Substitution effect
– Income effect
 Math of Price Changes
• So, we should be able to decompose the
derivative into those two parts as well.

– This is a tricky question: does any have an idea for

what, mathematically, the substitution effect is?

– Recall that graphically, the substitution effect is

how your demand changes as you move along an
indifference curve.
 Math of Price Changes
• Movement along an indifference curve is like
considering:

– “How would my demand for X change if the price

ratio changed, but I didn’t get any worse off”

– In other words, how would demand change as

price changes when, no matter what, you spend
enough money to get you to a utility constraint
 Math of Price Changes
• The substitution effect is the effect of a price
change on your compensated or Hicksian
demand.

• So to measure the substitution effect, we

would need to perform an expenditure
minimization problem.
Math of Price Changes
Math of Price Changes
Math of Price Changes
 Math of Price Changes
• Mathematically, our substitution effect is:
 Math of Price Changes
• Example calculating a substitution effect.
 Math of Price Changes
• What about the income effect?

– A little more straightforward, since earlier in this

unit we worked on the effect of income changes
on demand.

– Logically, the income effect will involve:

 Math of Price Changes
• Putting the income and substitution effects
together, so far we have:

• Now we just need to figure out how to

combine them.
 Math of Price Changes

• The derivative represents the effect of an

increase to price on demand.

• So should the income effect enter positively or

negatively?
 Math of Price Changes

• Negatively, since when the price goes up, the

income effect says it’s as if you get poorer
 Math of Price Changes

• There’s only 1 piece left that we’re missing.

• Imagine that you currently aren’t consuming

any X. When Px goes up, do you really get
poorer?
 Math of Price Changes

• A price change makes you poorer if it affects

something you consume a lot of.
– Think about rent. If rental prices in Eugene were
to double, it would make you a lot “poorer” in
terms of your ability to consume housing.
 Math of Price Changes

• So we’re going to scale the income effect by

the amount of X that you were consuming in
the first place.
 Math of Price Changes
• The income effect is thus:
 Math of Price Changes
• Example calculating an income effect.
 Math of Price Changes
• Example calculating an income effect.
 Math of Price Changes
• We’ve calculated both the income and
substitution effects for the utility function
U(x,y) = xy.

• So we can determine exactly how much of the

price response is due to substitution and
exactly how much is due to income.
 Math of Price Changes
• Decomposing the price derivative:

• This means X* = 5 and Y* = 5

 Math of Price Changes
• Decomposing the price derivative:
 Math of Price Changes
• Decomposing the price derivative:
 Math of Price Changes
• Decomposing the price derivative:
 Math of Price Changes

• This equation is called the Slutsky Equation.

• It’s the mathematical equivalent of the Slutsky

decomposition that we did graphically.
 Math of Price Changes

• Remember from the graphs: X is an ordinary

good if it’s a normal (non-inferior good).
– Easy to see in the equation: substitution effect
always negative, if X normal, income effect
negative too.
 Math of Price Changes

• If X is a Giffen good, it must be inferior:

– If overall derivative is positive, the income effect
must outweigh the substitution effect.
– Means income effect must be positive, which
means X must be inferior (income derivative
negative)
 Math of Price Changes

• Not all inferior goods are Giffen goods:

– Just because the income effect is positive does not
necessarily mean it outweighs the substitution
effect.
 Other Price Changes
• We started this unit by noting that demand
functions can be functions of own price, other
price and income:

• We’ve talked about own price and income, but

haven’t talked about other price yet.
 Other Price Changes
• Just like we had:
– Normal and inferior goods with income
– Ordinary and Giffen good with own price

• We have:
– Substitutes and compliments with other price
 Other Price Changes
• X is a substitute for Y if:

– The derivative of Y* with respect to Px is positive

– Think about Coke and Pepsi. If the price of Pepsi

doubles, my consumption of Coke will increase.
This is a relationship of substitution.
 Other Price Changes
• X is a compliment for Y if:

– The derivative of Y* with respect to Px is negative

– Think about bicycles and bike helmets: if the price

of a bike goes up, I’m less likely to also buy a
helmet. This is a complimentary relationship.
 Other Price Changes
• There are also lots of good that aren’t
substitutes or compliments: they’re demands
are independent of one another’s prices.

• Cobb-Douglas goods are an example:

 Other Price Changes
• We won’t do much with other price changes
beyond calculating whether goods are
substitutes or compliments.

– Remember the definitions.

 Market Demand
• This is the very last topic from consumer
theory.

• We’ve done a lot of work to understand and

characterize where the demand for good
comes from on an individual level.
 Market Demand
• Eventually, we want to talk about how
markets behave and where prices come from
in the first place.

• To do that, we need a measure of aggregate

or market demand.
 Market Demand
• This is generally a very simple process.

• Imagine that you’ve been given a utility

function to maximize.
– You did it, and wrote down the demand function.
 Market Demand
• Imagine that in the original utility function, X
was beer and Y was money to spend on
anything else.
– The price of money is $1
 Market Demand
• Now demand is just a function of Px and M.
Let’s assume a very simple function:
 Market Demand
• If I told you that a market consisted of 2
consumers with identical utility functions and
the same incomes:
– Market demand, Q with a D subscript, would just
be the sum of the 2 individuals demands:
 Market Demand
• If there were 10 identical consumers, we’d
have multiplied by 10 instead, etc.

• Graphically:
Market Demand
 Market Demand
• It can get a slightly more complicated when
consumers have different demands.
– Consider X* = M – Px.
 Market Demand
• It’s still that case that market demand is the
sum of the 2 individuals demands:
 Market Demand
• It’s still that case that market demand is the
sum of the 2 individuals demands:

• EXCEPT: once the price is 6 or higher, Bob’s

demand for zero, and Amanda is the only one
left in the market.
Market Demand
Market Demand
Market Demand
 Market Demand
• Whenever you add up linear demand curves
across people with different Px intercepts in
the demand curves, you’ll get a small kink in
the market demand function.
 Market Demand
• Example.
 Market Demand
• Example.
 Market Demand
• Example.
 Market Demand
• Example.
 Consumer Theory
• This is consumer theory:
– You’re interested demand for coffee.
 Consumer Theory
• This is consumer theory:
– You’re interested demand for coffee.
– Build utility functions for a couple different groups
in the market that represents their preferences for
coffee and other consumption.
 Consumer Theory
• This is consumer theory:
– You’re interested demand for coffee.
– Build utility functions for a couple different groups
in the market that represents their preferences for
coffee and other consumption.
– Solve the maximization problem and understand
how the solutions changes when inputs change.
 Consumer Theory
• This is consumer theory:
– You’re interested demand for coffee.
– Build utility functions for a couple different groups
in the market that represents their preferences for
coffee and other consumption.
– Solve the maximization problem and understand
how the solutions changes when inputs change.
– Add up the solutions across groups in the market
to measure the relationship between price and
demand.