2REASONS FOR THE DOWNWARD SLOPING DEMAND CURVE INCOME EFFECT: the change in consumption that results from the movement to a higher indifference curve.SUBSTITUTION EFFECT: the change in consumption that results from being on an indifference curve with a marginal rate of substitution.
3THE INCOME EFFECTSuppose a consumer makes $1000 a month and spends all of his money on either Pizza or Pepsi.Q of PepsiThe graph shows the amount the consumer could afford if the price of Pepsi is $2 and the price of pizza is $10.500100Q of Pizza
4THE INCOME EFFECT The point where he spends exactly $500 on each is: Q of PepsiBecause slope is:This line is called budget constraint.500Vertical distanceHorizontal distance250This would mean 500/100 or5 pepsi to 1 pizza.(We ignore the minus sign.)50100Q of Pizza
5Draw the budget constraint for a person with income of $1000 if the price of Pepsi is $5 and the price of pizza is $10.
6THE SUBSTITUTION EFFECT An indifference curve shows the bundles of consumption that make the consumer equally happy.Q of PepsiCIn this case, the indifference curves show the combinations of Pepsi and pizza it would take to make the consumer happy.DBI2AI1Q of Pizza
7A substitute good is defined as a good that, when its price rises causes a increase in the demand of another good (or visa versa).Substitute goods have a direct relationship between price of one good and demand for another.Pa Db
8A complementary good is defined as a good that, when its price rises causes a decrease in the demand of another good (or visa versa).Complementary goods have an inverse relationship between price of one good and demand for another.Pa Db
9THERE ARE FOUR PROPERTIES OF THE INDIFFERENCE CURVE
101) Higher indifference curves are preferred to lower ones. Consumers usually prefer more to less.Therefore, a consumer would prefer point D to point A because it is on a higher indifference curve.Q of PepsiCDBI2AI1Q of Pizza
112) Indifference curves are downward sloping. The IC reflects the rate at which consumers are willing to substitute one good for another. Therefore, if Q of one good is reduced, then the Q of the other must increase to make the consumer equally happy.Q of PepsiCDBI2AI1Q of Pizza
123) Indifference curves do not cross. This could never happen. According to these indifference curves, the consumer would be equally happy at points A, B, and C, even though point C has more of both goods.Q of PepsiACBQ of Pizza
134) Indifference curves are bowed inward. This shape implies that the marginal rate of substitution (MRS) depends on the Q of the two goods the consumer is consuming.When IC are less bowed, the goods are easy to substitute for each other.Q of PepsiMRS = 614843BMRS = 1AI1Q of Pizza
14The Income Effect is shown in the movement from point B to point C. The effect of a price change can be broken down in to the income effect and the substitution effect.Point A is the initial optimum, and the movement along the IC to point B represents the Substitution Effect.Q of PepsiCBThe Income Effect is shown in the movement from point B to point C.AQ of Pizza
15To derive the DEMAND CURVE, notice that when the price of Pepsi falls from $2 to $1……. Q of Pepsithe consumer’s optimum moves from point A to B, and the optimum quantity of Pepsi consumed rises from 250 to 750.B750250AQ of Pizza
16Therefore, the demand curve reflects this relationship between price and quantity. Price of PepsiA$2$1BQuantity of Pepsi
17Source: Principles of Economics, Third Edition, by N. Gregory Mankiw. PowerPoint created by Virginia MeachumSource: Principles of Economics, Third Edition, by N. Gregory Mankiw.