WHY DOES THE DEMAND CURVE SLOPE DOWNWARD?

REASONS 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.

THE INCOME EFFECT Suppose a consumer makes $1000 a month and spends all of his money on either Pizza or Pepsi. Q of Pepsi The graph shows the amount the consumer could afford if the price of Pepsi is $2 and the price of pizza is $10. 500 100 Q of Pizza

THE INCOME EFFECT The point where he spends exactly $500 on each is: Q of Pepsi Because slope is: This line is called budget constraint. 500 Vertical distance Horizontal distance 250 This would mean 500/100 or 5 pepsi to 1 pizza. (We ignore the minus sign.) 50 100 Q of Pizza

Draw the budget constraint for a person with income of $1000 if the price of Pepsi is $5 and the price of pizza is $10.

THE SUBSTITUTION EFFECT An indifference curve shows the bundles of consumption that make the consumer equally happy. Q of Pepsi C In this case, the indifference curves show the combinations of Pepsi and pizza it would take to make the consumer happy. D B I2 A I1 Q of Pizza

A 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

A 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

THERE ARE FOUR PROPERTIES OF THE INDIFFERENCE CURVE

1) 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 Pepsi C D B I2 A I1 Q of Pizza

2) 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 Pepsi C D B I2 A I1 Q of Pizza

3) 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 Pepsi A C B Q of Pizza

4) 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 Pepsi MRS = 6 14 8 4 3 B MRS = 1 A I1 Q of Pizza 2 3 6 7

The 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 Pepsi C B The Income Effect is shown in the movement from point B to point C. A Q of Pizza

To derive the DEMAND CURVE, notice that when the price of Pepsi falls from $2 to $1……. Q of Pepsi the consumer’s optimum moves from point A to B, and the optimum quantity of Pepsi consumed rises from 250 to 750. B 750 250 A Q of Pizza

Therefore, the demand curve reflects this relationship between price and quantity. Price of Pepsi A $2 $1 B Quantity of Pepsi 250 750

Source: Principles of Economics, Third Edition, by N. Gregory Mankiw. PowerPoint created by Virginia Meachum Source: Principles of Economics, Third Edition, by N. Gregory Mankiw.