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© 2008 Pearson Addison Wesley. All rights reserved Chapter Four Demand

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© 2008 Pearson Addison Wesley. All rights reserved. 4-2 Demand In this chapter, we examine five main topics. –Deriving Demand Curves –Effects of an Increase in Income –Effects of a Price Increase –Cost-of-living adjustments –Revealed Preference

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© 2008 Pearson Addison Wesley. All rights reserved. 4-3 Deriving Demand Curves System of Demand Equation We used calculus to maximize utility subject to a budget constraint. In doing so, we solved for the optimal quantities that a consumer chooses as functions of prices and income. That is, we solved for the consumer’s system of demand functions for these goods. where is the price of pizza, is the price of burritos, and is her income.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-4 Deriving Demand Curves Graphical Interpretation An individual chooses an optimal bundle of goods by picking the point on the highest indifference curve that touches the budget line. When a price changes, the budget constraint the consumer faces shifts, so the consumer choose a new optimal bundle.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-5 Deriving Demand Curves By varying one price and holding other prices and income constant, we can determine how the quantity demanded changes as the price changes, which is the information we need to draw the demand curve.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-6 Deriving Demand Curves We derive a demand curve using the information about tastes from indifference curves. These indifference curves are convex to the origin: Mimi views beer and wine as imperfect substitutes. We can construct Mimi’s demand curve for beer by holding her budget, her tastes, and the price of wine constant at their initial levels and varying the price of beer.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-7 Deriving Demand Curves Price-consumption curve, is the line through the equilibrium bundles, such as,, and, that Mimi would consume at each price of beer, when the price of wine and Mimi’s budget are held constant.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-8 Figure 4.1(a) Deriving Mimi’s Demand Curve

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© 2008 Pearson Addison Wesley. All rights reserved. 4-9 Figure 4.1(b) Deriving Mimi’s Demand Curve

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© 2008 Pearson Addison Wesley. All rights reserved. 4-10 Effects of an Increase in Income How Changes in Income Shift Demand Curves –We illustrate the relationship between the quantity demanded and income by examining how Mimi’s behavior changes when her income rises, while the prices of beer and wine remain constant.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-11 Figure 4.2(a) Effect of a Budget Increase

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© 2008 Pearson Addison Wesley. All rights reserved. 4-12 Figure 4.2(b) Effect of a Budget Increase

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© 2008 Pearson Addison Wesley. All rights reserved. 4-13 Figure 4.2(c) Effect of a Budget Increase

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© 2008 Pearson Addison Wesley. All rights reserved. 4-14 Effects of an Increase in Income The income-consumption curve through bundles,, and in panel a shows how Mimi’s consumption of beer and wine increases as her income rises. As Mimi’s income goes up, her consumption of both wine and beer increases.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-15 Effects of an Increase in Income Engel curve –the relationship between the quantity demanded of a single good and income, holding prices constant

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© 2008 Pearson Addison Wesley. All rights reserved. 4-16 Consumer Theory and Income Elasticities Income elasticities tell us how much the quantity demanded changes as income increases. We can use income elasticities to summarize the shape of the Engel curve, the shape of the income-consumption curve, or the movement of the demand curves when income increases.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-17 Income Elasticities We defined the income elasticities of demand in Chapter 3 as where is the Greek letter xi

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© 2008 Pearson Addison Wesley. All rights reserved. 4-18 Consumer Theory And Income Elasticities normal good –a commodity of which as much or more is demanded as income rises inferior good –a commodity of which less is demanded as income rises

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© 2008 Pearson Addison Wesley. All rights reserved. 4-19 Income-Consumption Curves and Income Elasticities The shape of the income-consumption curve for two goods tells us the sign of the income elasticities: whether the income elasticities for those goods are positive or negative.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-20 Some Goods Must Be Normal It is impossible for all goods to be inferior. If both goods were inferior, Peter would buy less of both goods as his income rises-which makes no sense.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-21 Figure 4.3 Income-Consumption Curves and Income Elasticities

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© 2008 Pearson Addison Wesley. All rights reserved. 4-22 Figure 4.4 A Good That Is Both Inferior and Normal

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© 2008 Pearson Addison Wesley. All rights reserved. 4-23 Weighted Income Elasticities The weighted sum of a consumer’s income elasticities equals one.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-24 Effects of a Price Increase An increase in a price of a good, holding other prices and income constant, has two effects on an individual’s demand. One is the substitution effect: If utility is held constant, as the price of the good increases, consumers substitute other, now relatively cheaper goods for that one.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-25 Effects of a Price Increase The other is the income effect: An increase in price reduces a consumer’s buying power, effectively reducing the consumer’s income and causing the consumer to buy less of at least some goods.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-26 Income and Substitution Effects with a Normal Good The substitution effect is the change in the quantity of a good that a consumer demands when the good’s price changes, holding other prices and the consumer’s utility constant The income effect is the change in the quantity of a good a consumer demands because of a change in income, holding prices constant.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-27 Income and Substitution Effects with a Normal Good The total effect from the price change is the sum of the substitution and income effects, as the arrows show. Mimi’s total effect (in gallons of beer per year) from a drop in the price of beer is

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© 2008 Pearson Addison Wesley. All rights reserved. 4-28 Income and Substitution Effects with a Normal Good Because indifference curves are convex to the origin, the substitution effect is unambiguous: More of a good is consumed when its price falls. A consumer always substitutes a less expensive good for a more expensive one, holding utility constant.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-29 Income and Substitution Effects with a Normal Good The direction of the income effect depends on the income elasticity. Because beer is a normal good for Mimi, her income effect is positive. Thus both Mimi’s substitution effect and her income effect go in the same direction.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-30 Figure 4.5 Substitution and Income Effects with Normal Goods

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© 2008 Pearson Addison Wesley. All rights reserved. 4-31 Income and Substitution Effects with an Inferior Good If a good is inferior, the income effect goes in the opposite direction from the substitution effect. For most inferior goods, the income effect is smaller than the substitution effect. As a result, the total effect moves in the same direction as the substitution effect, but the total effect is smaller.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-32 Income and Substitution Effects with an Inferior Good A good is called a Giffen good if a decrease in its price causes the quantity demanded to fall. The Law of Demand was an empirical regularity, not a theoretical necessity. Although it’s theoretically possible for a demand curve to slope upward, economists have found few, if any, real-world examples of Giffen goods.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-33 Compensated Demand Curve We could derive a compensated demand curve, where we determine how the quantity demanded changes as the price rises, holding utility constant, so that the change in the quantity demanded reflects only pure substitution effects when the price changes. It is called the compensated demand curve because we would have to compensate an individual-give the individual extra income- as the price rises so as to hold the individual’s utility constant.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-34 Figure 4.6 Deriving Jackie’s Compensated Demand Curve

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© 2008 Pearson Addison Wesley. All rights reserved. 4-35 Slutsky Equation The usual price elasticity of demand,, captures the total effect of a price change. We can break this price elasticity of demand into two terms involving elasticities that capture the substitution and income effects. We measure the substitution effect using the pure substitution elasticity of demand,, which is the percentage that the quantity demanded falls for a given percentage increase in price if we compensate the consumer to keep the consumer’s utility constant.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-36 Slutsky Equation This relationship among the price elasticity of demand,, the substitution elasticity of demand,, and the income elasticity of demand,, is the Slutsky equation.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-37 Cost-of-Living Adjustments By knowing both the substitution and effects, we can answer questions that we could not if we knew only the total effect.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-38 Inflation Indexes The price of most goods rise over time. We call the increase in the overall price level inflation.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-39 Real Versus Nominal Prices The actual price of a good is called the nominal price. The price adjusted for inflation is the real price.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-40 Calculating Inflation Indexes The CPI for the first year is the amount of income it takes to buy the market basket actually purchased that year: The cost of buying the first year’s bundle in the second year is

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© 2008 Pearson Addison Wesley. All rights reserved. 4-41 Calculating Inflation Indexes To calculate the rate of inflation, we determine how much more income it would take to buy the first year’s bundle in the second year, which is the ratio of to :

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© 2008 Pearson Addison Wesley. All rights reserved. 4-42 Calculating Inflation Indexes The CPI is a weighted average of the price increase for each good, and, where the weights are each good’s budget share in the base year, and.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-43 CPI adjustment CPI adjustment to income does not keep an individual on his original indifference curve. Indeed, this person is better off in the second year than in the first. The CPI adjustment overcompensates for the change in inflation in the sense that his utility increases.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-44 Figure 4.7 CPI Adjustment

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© 2008 Pearson Addison Wesley. All rights reserved. 4-45 Revealed Preferences If we observe a consumer’s choice at many different prices and income levels, we can derive the consumer’s indifference curves using the theory of revealed preferences( Samuelson, 1947). The basic assumption of the theory of revealed preference is that a consumer chooses bundles to maximize utility subject to a budget constraint: The consumer chooses the best bundle that the consumer can afford.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-46 Substitution Effect One of the clearest and most important results from consumer theory is that the substitution effect is negative: The Law of Demand holds for compensated demand curves.

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© 2008 Pearson Addison Wesley. All rights reserved. 4-47 Figure 4.8 Revealed Preference

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© 2008 Pearson Addison Wesley. All rights reserved. 4-48 Consumer Price Indices (CPI)

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© 2008 Pearson Addison Wesley. All rights reserved. 4-49 Consumer Price Indices (CPI)

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