EC10C Lecture Notes Unit 3 Part 3

In this section of the Lecture Notes we look at the : 1. Income Consumption Curve and the Engel Curve. 2. Price Consumption Curve and the Derivation of the Demand Curve from the Price Consumption Curve. 3. Decomposition of the Total Price Effect in to the Income and Substitution Effects for the cases of Normal, Inferior and Giffen goods. 4. The difference between individual demand and market demand.

The Theory of the Consumer (Contd)

The Income Consumption Curve This curve shows the different consumer equilibria which result as we change the consumers income while holding the prices of the two goods constant.
Good Y

The Income Consumption Curve

IC 3 IC 2 IC 1

0
BL 1 BL 2 BL 3

Good X

The Theory of the Consumer (Contd)

The Engel Curve can be derived from the points along the Income Consumption Curve. The Engel curve shows the relationship between the amount of the good that is bought and income. The Engel curve for normal goods is upward sloping which denotes a positive relationship between demand for the good and income. The Engel curve for an inferior good is downward sloping which means that if income increases, then the demand for that good falls and vice versa.

The Theory of the Consumer (Contd)

Panel A shows the Engel curve for a normal good, while panel B shows the Engel curve for an inferior good.

(A) Normal Good Income

(B) Inferior Good Income

Engel Curve

Engel Curve

0
Good X or Good Y

0 Good X or Good Y

The Theory of the Consumer (Contd)

The Price Consumption Curve This curve shows the different consumer equilibria which result as we change one of the prices (the price of good X) while holding income and the price of the other good (good Y) constant.

Good Y

The Price Consumption Curve

IC 3
IC 2 IC 1

Good X
BL 1 BL 2 BL 3

The Theory of the Consumer (Contd)

We can derive the demand curve from the points along the price consumption curve. The higher prices along the demand curve correspond to the tangency points which are closer to the point of origin on the graph showing the price consumption curve and the various consumer equilibria. The following graph shows this derivation:

The Theory of the Consumer (Contd)

Good Y

The Price Consumption Curve

IC 3 IC 2 IC 1

0
BL 1 BL 2 BL 3

Good X

Price P1

P2 P3
Demand Curve X2 X3 Quantity Demanded

0 X1

The Theory of the Consumer (Contd)

The Decomposition of the Total Price Effect (TPE)

The Income and Substitution Effects Revisited

The Income effect is the change in the purchasing power of income (or real income) that occurs when the price of one of the good changes. The Substitution effect occurs when the change in price of one of the goods (while holding the other goods price and income constant) results in a change in the quantity that is demanded of that good whose price changed.

The Theory of the Consumer (Contd)

We will break up the total price effect (TPE) into the substitution and income effects. Thus TPE = SE + IE The substitution effect (SE) is always negative. This means that the price of a good and the quantity that is consumed of it (or bought) will always move in opposite directions. Normal Goods: The income effect (IE) is positive for normal goods. This means that an increase in real income (or purchasing power) will increase the amount of that good which is bought. Inferior Goods: The income effect is always negative for inferior goods. This means that an increase in real income (or purchasing power) will reduce the amount of the good that is bought.

The Theory of the Consumer (Contd)

Giffen Good: If the price of a Giffen good increases, then the quantity demanded of that good also increases.
Giffen goods are usually goods whose prices are seen as being an indicator of their value, for example pieces of art. The income effect for Giffen goods is also negative. Now we will consider some fundamental rules:

The Theory of the Consumer (Contd)

1. For normal goods, the substitution effect is reinforced by the income effect. In other words, the SE and IE have the same impact on the quantity of the good that is bought. 2. For inferior goods, the substitution effect will be larger than the income effect, i.e. SE > IE. 3. For Giffen goods, the income effect is larger than the substitution effect, i.e. IE > SE. We will break down the total price effect for all three types of goods when the price of good X decreases.

The Theory of the Consumer (Contd)

The effect of a decrease in the price of normal good on the quantity of that good that is consumed. Normal Good SE and IE have the same impact on the quantity consumed of the good. SE: P Q IE: TPE:

P RI Q
P Q

P is price, Q is quantity that is consumed of the good and RI is real income (or the purchasing power of income).

The Theory of the Consumer (Contd)

Normal Good

Good Y

A
1
2

IC 2 IC 1

0
X*1 X X*2

Good X B C

The Theory of the Consumer (Contd)

Normal Good (Contd)

Our initial consumer equilibrium is at 1, where the original budget line AB forms a tangent to the indifference curve IC 1. A decrease in the price of the good X will mean that more of that good can be purchased. The move from 1 to 2 is the substitution effect. The substitution effect is shown by dashed budget line AB, which holds real income (purchasing power) constant. The budget line AB keeps us on the same indifference curve IC 1. The substitution effect says that if the price of a good falls then persons will switch to consuming more that good.

The Theory of the Consumer (Contd)

Normal Good (Contd) The move from 2 to 3 is the income effect. The budget line AC does not hold purchasing power constant. The income effect is where the decrease in price increases the purchasing power of the consumer. This increase in purchasing power means that the consumer can now move to a higher indifference curve IC 2 and budget line AC, and consume more of the good. The total price effect is the move from 1 to 3, which is the sum of the substitution and income effects.

The Theory of the Consumer (Contd)

The effect of a decrease in the price of an inferior good (good X) on the quantity of that good that is consumed.

Inferior Good

SE IE
SE: IE: TPE:

P Q
P RI Q
P Q

The Theory of the Consumer (Contd)

Inferior Good

Good Y

A A
1 2 3

IC 2 IC 1

0
X*2 X

Good X B B C

The Theory of the Consumer (Contd)

Inferior Good (Contd)

The original equilibrium is at 1, where the budget line AB forms a tangent to the indifference curve IC 1. The substitution effect is from 1 to 2 and the dashed budget line AB keeps real income constant. Although it is an inferior good, the substitution effect will mean that the decrease in price will still result in an increase in quantity demanded.

The Theory of the Consumer (Contd)

Inferior Good (Contd) The move from 2 to 3 is the income effect. Although the price has decreased and real income has increased, there is a reduction in the quantity consumed of the inferior good due to the negative income effect. The income effect is dominated by the substitution effect and so the decrease in the price of the good will have the total price effect of an increase in the quantity that is consumed of the inferior good.

The Theory of the Consumer (Contd)

The effect of a decrease in the price of the Giffen good on the quantity of that good that is consumed.

Giffen Good

IE SE
SE: IE: TPE:

P Q
P RI Q
P Q

The Theory of the Consumer (Contd)

Giffen Good

Good Y A

IC 2
1 2

IC 1 0
X*2 X*1 X

Good X B C

The Theory of the Consumer (Contd)

Giffen Good (Contd) The initial equilibrium is at 1, where the budget line AB forms a tangent to the indifference curve IC 1. The substitution effect is from 1 to 2. The real income is held constant with the dashed budget line AB and the same indifference curve IC 1. The income effect is from 2 to 3. The income effect is negative for the Giffen good. The increase in real income from the decrease in price will reduce the demand for the Giffen good.

The Theory of the Consumer (Contd)

Giffen Good (Contd) The income effect outweighs the substitution effect, so the decrease in the price of the Giffen good results in a reduction in the quantity consumed of that good. This result is in keeping with the definition of a Giffen good price and quantity demanded move in the same direction.

The Theory of the Consumer (Contd)

The effect of an increase in the price of normal good on the quantity of that good that is consumed Normal Good SE and IE have the same impact on the quantity of the good. SE: P Q IE: TPE:

P RI Q
P Q

P is price, Q is quantity that is consumed of the good and RI is real income (or the purchasing power of income).

The Theory of the Consumer (Contd)

The effect of an increase in the price of an inferior good (good X) on the quantity of that good that is consumed

Inferior Good

SE IE
SE: IE: TPE:

P Q
P RI Q
P Q

The Theory of the Consumer (Contd)

The effect of an increase in the price of the Giffen good on the quantity of that good that is consumed

Giffen Good

IE SE
SE: IE: TPE:

P Q
P RI Q
P Q

The Difference between Individual and Market Demand

Individual demand refers to the amount of the good that is demanded by one person at different prices. The Market Demand refers to the total amount of the good that is demanded by all the buyers at different prices.

We can get the Market Demand by summing all the individual demands at the different prices.

Summary
For this Unit we have looked at: Factors determining Market Demand. Price Elasticity of Demand, Income Elasticity of Demand and Cross-Price Elasticity of Demand. The Theory of the Consumer Budget Constraint, Budget Line, Indifference Curve, Consumer Equilibrium. Price and Income Consumption Curves. The Decomposition of the Total Price Effect (TPE) in to the Income and Substitution Effects. The difference between individual and market demand.