© 2009 Pearson Education Canada 4/1 Chapter 4 More Demand Theory

© 2009 Pearson Education Canada 4/2 The Law of Demand  The law of demand implies an inverse relationship between price and quantity demanded.  When the price and quantity of a good are positively related, the good is called a Giffen Good.

© 2009 Pearson Education Canada 4/3 Income and Substitution Effects  The substitution effect of a change in p 1 is associated with the relative change in the price of good 1.  The income effect of a change in p 1 is associated with the change in real income.

© 2009 Pearson Education Canada 4/4 Figure 4.1 A Giffen good

© 2009 Pearson Education Canada 4/5 Figure 4.2 Income and substitution effects for a price increase

© 2009 Pearson Education Canada 4/6 Figure 4.3 Income and substitution effects for a price decrease

© 2009 Pearson Education Canada 4/7 Income and Substitution Effects  If indifference curves are smooth and convex and if the consumer buys a positive quantity of both goods, then the substitution effect is always negatively related to the price change.  For a normal good, the income effect is negatively related to the price change.  For an inferior good, the income effect is positively related to the price change.

© 2009 Pearson Education Canada 4/8 Compensatory Income  After a price change, the minimum income that allows the consumer to attain the original indifference curve is called the compensatory income.  The budget line associated with the compensatory income is the compensated budget line.

© 2009 Pearson Education Canada 4/9 Figure 4.4 The nonpositive substitution effect

© 2009 Pearson Education Canada 4/10 The Compensated Demand Curve  The compensated demand curve identifies the consumer’s utility maximizing bundle when, as a result of a price change, the consumer’s income is adjusted to keep him/her on the same indifference curve.  The compensated demand curve reflects the substitution effect and cannot be upward sloping.

© 2009 Pearson Education Canada 4/11 Figure 4.5 The compensated demand curve

© 2009 Pearson Education Canada 4/12 Compensating and Equivalent Variation  Equivalent variation identifies the variation in income that is equivalent to being able to buy good x at a given price.  Compensating variation identifies the variation in income that compensates for the right to buy good x at a given price.

© 2009 Pearson Education Canada 4/13 Figure 4.8 Measuring the benefit of a new good

© 2009 Pearson Education Canada 4/14 From Figure 4.8  Mr. Polo’s non-member initial equilibrium is E 0 on I 0.  Equilibrium as a member is E 1 on I 1.  Equivalent variation is EV. With no membership, this additional income would yield indifference curve I 1.  Compensating variation is CV. Given that he is a member, this reduction in income yields indifference curve I 0.

© 2009 Pearson Education Canada 4/15 Figure 4.9 Measuring the cost of a price change

© 2009 Pearson Education Canada 4/16 From Figure 4.9  Low price of P 1 gives equilibrium of E 0 on I 0.  Equilibrium with higher price of P 1 is at E 1 on I 1.  With a lower price, reducing income by EV yields I 1.  With a higher price, increasing income by CV would yield I 0.

© 2009 Pearson Education Canada 4/17 Figure 4.10 The case in which CV equals EV

© 2009 Pearson Education Canada 4/18 Figure 4.11 Consumer’s surplus for a new good

© 2009 Pearson Education Canada 4/19 Figure 4.12 Consumer’s surplus for a price reduction

© 2009 Pearson Education Canada 4/20 Figure 4.13 Marginal values and marginal rates of substitution

© 2009 Pearson Education Canada 4/21 Figure 4.14 Total value and marginal value

© 2009 Pearson Education Canada 4/22 Figure 4.15 Equal marginal values

© 2009 Pearson Education Canada 4/23 Application: Two Part Tariff  What combination of camera price (p c ) and film price (p 1 ) maximize profits?  The cost of producing a camera is $5, the cost of making film is 1$.  The firm’s profit maximizing strategy is to sell the film at cost and charge the corresponding reservation price for the camera, area GAF (Fig 4.16).

© 2009 Pearson Education Canada 4/24 Figure 4.16 The Polaroid pricing problem

© 2009 Pearson Education Canada 4/25 Figure 4.17 The Paasche quantity index

© 2009 Pearson Education Canada 4/26 Paasche Quantity Index

© 2009 Pearson Education Canada 4/27 Laspeyres Quantity Index

© 2009 Pearson Education Canada 4/28 Price Indices Price Indices

© 2009 Pearson Education Canada 4/29 Figure 4.18 An index-number puzzle