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Steven Landsburg, University of Rochester Chapter 4 Consumers in the Marketplace Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

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Landsburg, Price Theory and Applications, 6th edition2 Introduction Consumption choices change as a function of price and income Prices go up, quantity demanded goes down Prices go up, budget line pivots and consumers choose a new consumption point Reconcile these two stories

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Landsburg, Price Theory and Applications, 6th edition3 Changes in Income Use composite good convention Changes in income and budget line –Result in a parallel shift of the budget line Changes in income and optimum point –If good normal, as income rises, consumption increases –If good inferior, as income rises, consumption decreases

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Landsburg, Price Theory and Applications, 6th edition4 EXHIBIT 4.3Normal and Inferior Goods

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Landsburg, Price Theory and Applications, 6th edition5 Engel Curve Curve showing for fixed prices, relationship between income and quantity of good consumed Need to know prices of goods consuming and indifference curves –Can generate coordinates of points on Engel curve Shape of Engel curve –Upward-sloping if good X is normal If consumer income rises, consumes more of good X –Downward-sloping if good X is inferior If consumer income rises, consumes less of good X

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Landsburg, Price Theory and Applications, 6th edition6 EXHIBIT 4.4Constructing the Engel Curve

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Landsburg, Price Theory and Applications, 6th edition7 Changes in Price Income and price of good Y remain fixed Change in price of X has no effect on y-intercept of budget line –Budget line pivots around y-intercept –Rise in price of X causes budget line to pivot inward –fall in price of X causes budget line to pivot outward Changes in optimum point –Located anywhere along new budget line

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Landsburg, Price Theory and Applications, 6th edition8 Giffen Goods If price of X increases, quantity demanded decreases –Follows law of demand –Goods called non-Giffen goods If price of X increases, quantity demanded increases –Violates law of demand –Goods called Giffen goods Giffen goods rare or nonexistent –Theory of indifference curves indicates exceptions to law of demand

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Landsburg, Price Theory and Applications, 6th edition9 EXHIBIT 4.7Non-Giffen Goods and Giffen Goods

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Landsburg, Price Theory and Applications, 6th edition10 The Demand Curve Engel curve relationship to demand curve –Engel curve: relationship between income and consumption Plots income on horizontal axis and consumption on the vertical axis –Demand curve: relationship between price and consumption Plots price on the vertical axis and consumption on the horizontal axis

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Landsburg, Price Theory and Applications, 6th edition11 Constructing the Demand Curve Derived from indifference curves –Find price of X –Draw budget line given income and prices –Find tangency between budget line and indifference curve –Read off quantity of X –Plot point on demand curve relating price to quantity –Repeat the process for additional points on the demand curve

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Landsburg, Price Theory and Applications, 6th edition12 EXHIBIT 4.10Income and Substitution Effects

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Landsburg, Price Theory and Applications, 6th edition13 Shape of Demand Curve Slopes downward If Giffen good, slopes upward Demand and indifference curves cannot be drawn on same graph –Require different axes

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Landsburg, Price Theory and Applications, 6th edition14 Income and Substitution Effects Why no Giffen goods in reality? –When price increases, expect quantity demanded decrease Why this expectation? –Income effect Price rises Can no longer afford previous basket Decrease (increase) consumption if normal (inferior) good –Substitution effect Price rises Adjust consumption of goods whose price above marginal value

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Landsburg, Price Theory and Applications, 6th edition15 Isolating the Substitution Effect Suppose given just enough money to offset income effect –Compensated: same indifference curve originally on Graph shows reduction in consumption

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Landsburg, Price Theory and Applications, 6th edition16 Combining the Effects Know how substitution effect changes consumption Can deduce impact of income effect

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Landsburg, Price Theory and Applications, 6th edition17 EXHIBIT 4.8Constructing the Demand Curve

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Landsburg, Price Theory and Applications, 6th edition18 Why Demand Curves Slope Downward: Normal Goods Geometric Observations –Price goes up, substitution effect leads to less consumption –Move from compensated line to new line, income falls, consume less of good if normal Demand curve for normal good –Both effects move consumer leftward –Normal goods are not Giffen goods

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Landsburg, Price Theory and Applications, 6th edition19 Why Demand Curves Slope Downward: Inferior Goods Demand curve for inferior goods –Effects move in opposite directions and not as easily analyzed as normal good –Inferior good non-Giffen is substitution effect exceeds income effect –Inferior good Giffen if income effect exceeds substitution effect Size of income effect –Income effect of price change large if good large fraction of consumer expenditures Giffen goods revisited –Giffen goods are inferior –Giffen goods account for a large portion of consumer expenditures –Conditions above explain why so rare

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Landsburg, Price Theory and Applications, 6th edition20 EXHIBIT 4.11Income and Substitution Effects for an Inferior Good

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Landsburg, Price Theory and Applications, 6th edition21 Compensated Demand Curve Curve showing, for each price, what the quantity demanded would be if the consumer were income-compensated for all price changes Allows for isolation of substitution effect Confirms that compensated demand curve downward sloping

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Landsburg, Price Theory and Applications, 6th edition22 EXHIBIT 4.12Compensated and Uncompensated Demand Curve

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Landsburg, Price Theory and Applications, 6th edition23 Elasticities Anticipate changes in consumer buying habits Predictions –If income increases, consumer buys more –In price falls, consumer buys more No predictions about magnitude of change –Want to know by how much consumption and expenditures change

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Landsburg, Price Theory and Applications, 6th edition24 Income Elasticity of Demand Depicted by Engel curve Could measure response by slope of curve –Slope arbitrary –Dependent on units good X measured in and units income measured in Adopt measure not dependent on units of measurement

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Landsburg, Price Theory and Applications, 6th edition25 Income Elasticity Continued If your income increased by one dollar, by how many units would you increase your consumption of X? If your income increases by 1%, by what percent would you increase your consumption of X? Answer: elasticity of Engel curve –Income elasticity of demand

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Landsburg, Price Theory and Applications, 6th edition26 Income Elasticity Continued Income elasticity =

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Landsburg, Price Theory and Applications, 6th edition27 Price Elasticity of Demand Price elasticity =

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Landsburg, Price Theory and Applications, 6th edition28 More about Price Elasticity Demand highly elastic when price elasticity of demand has large absolute value Why? –Availability of substitutes

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Landsburg, Price Theory and Applications, 6th edition29 Relationship between Income and Price Elasticity of Demand Determinants of value of price elasticity of demand –Size of substitution effect –Size and direction of income effect Larger for goods that take up large fraction of income Larger for goods with high income elasticity of demand Income effect depends on whether good normal or inferior –Normal: larger income effect means larger price elasticity of demand –Inferior: larger income effect means smaller price elasticity of demand

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Landsburg, Price Theory and Applications, 6th edition30 Cross Elasticity of Demand Change in price of some other good Y may affect demand for X Measure size of effect using cross elasticity of demand –Percent change in consumption X divided by the percent change in the price of Y –Substitutes: cross price elasticity of demand positive –Complements: cross price elasticity of demand negative Used to determine level and amount of monopoly power held by certain firms in antitrust cases

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