1. PPA 723: Managerial Economics
Lecture 8:
Deriving Demand Curves

2. Managerial Economics, Lecture 8: Deriving Demand Curves
Outline
Deriving Demand Curves
Income Elasticities of Demand
Income and Substitution Effects

3. Managerial Economics, Lecture 8: Deriving Demand Curves
Trace out the demand curve for Good B from a household-maximization diagram by
holding income and the price of Good A constant
and varying the price of Good B
Then plot the price-quantity pairs in a new graph.

4. Managerial Economics, Lecture 8: Deriving Demand Curves
Pulling Out Price and Quantity Combinations B
, Burritos
Price of Pizza Doubles
per semester 25 L 1 ( p
= $1) Z
Price-Consumption
Curve L 2 ( p
= $2) Z 15 25 27 50 Z
, Pizzas per semester

5. Managerial Economics Deriving Demand Curves
(a) Indifference Curves and Budget Constraints
Wine, Gallons
per year
12.0
Price-consumption curve e
Figure 5.1 Deriving
an Individual’s
Demand Curve 3
5.2 e 2
4.3 e I 3 1
2.8 I 2 L 1 ( p
= $12) I 1 L 2 ( p
= $6) L 3 ( p
= $4) b b b
26.7
44.5
58.9
Beer, Gallons per year p
, $ per unit
(b) Demand Curve b
12.0 E 1
6.0 E 2 E
4.0 3 D 1
, Demand for beer
26.7
44.5
58.9
Beer, Gallons per year

6. Managerial Economics, Lecture 8: Deriving Demand Curves
How Income Changes Shift Demand Curves
In household-maximization diagram, hold prices fixed and vary income.
The increase in income causes
movement along the income-consumption curve,
shift of the demand curve,
movement along the Engel curve.

7. Managerial Economics, Lecture 8: Deriving Demand Curves
Income-Consumption Curve
An increase in income shifts the budget line outward.
An income-consumption curve plots combinations of Good A and Good B at different income levels.

8. Managerial Economics, Lecture 8: Deriving Demand Curves
Shifts in the Demand Curve
Recall that a demand curve plots price-quantity combinations for one good.
A change in income changes the quantity for a good, holding price constant.
So at each price, plot how quantity consumed increases with income.

9. Managerial Economics, Lecture 8: Deriving Demand Curves
Engle Curves
An Engle curve plots quantity consumed for a good (X-axis) against income (Y-axis), holding prices constant.
It shows how consumption of a good changes as income changes.

10. Managerial Economics, Lecture 8: Deriving Demand Curves
Pulling Out Income and Quantity Combinations
Income Doubles B
, Burritos
per semester 50 L 3 ( Y =
$100)
Income-Consumption
Curve 25 L 1 ( Y =
$50) 25 50 55
100 Z
, Pizzas per semester

11. Managerial Economics, Lecture 8: Deriving Demand Curves
(a) Indifference Curves and Budget Constraints
Wine, Gallons
per year L 3 L 2
Income-consumption L 1
curve e 3
7.1
4.8 e 2
Figure 5.2 Effect of a Budget
Increase on an Individual’s
Demand Curve 3
2.8 e I 1 I 2 I 1
26.7
38.2
49.1
Beer, Gallons per year
(b) Demand Curves
Price of beer,
$ per unit E 1 E 12 2 E 3 D 3 D 2 D 1
26.7
38.2
49.1
Beer, Gallons per year
(c) Engel Curve Y
, Budget
Engel curve for beer Y
= $837 3 E * 3 Y
= $628 2 E * 2 Y 1
= $419 E 1 *
26.7
38.2
49.1
Beer, Gallons per year

12. Managerial Economics, Lecture 8: Deriving Demand Curves
Income Elasticities
Income elasticity:
Normal good:  > 0
Inferior good:   0
Note:  is Greek xi (pronounced ks-eye).

13. Managerial Economics, Lecture 8: Deriving Demand Curves
Income-Consumption Curves and Income Elasticities
The shape of the income-consumption curve for 2 goods reveals the sign of the income elasticities.
Some goods must be normal; not all goods can be inferior.

14. Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.3 Income-Consumption Curves and Income Elasticities
Housing, Square feet
per year
Food inferior,
housing normal
ICC 1 L 2 a
Food normal,
housing normal
ICC 2 L 1 b e c
Food normal,
ICC 3
housing inferior I
Food, Pounds per year

15. Managerial Economics, Lecture 8: Deriving Demand Curves
Applications to Policy
Policy makers may care about the consumption of particular goods, such as health care or housing.
If we know income elasticities, we can predict the extent to which people buy more of these goods when
they receive a cash grant
incomes in general rise.

16. Managerial Economics, Lecture 8: Deriving Demand Curves
The Effects of a Price Change
As price of Good A goes up (all else the same), there are two impacts in the quantity of Good A that is consumed:
the substitution effect
the income effect

17. Managerial Economics, Lecture 8: Deriving Demand Curves
Substitution Effect
Consumers substitute other, now relatively cheaper, goods for the good subject to a price increase.
The direction of the substitution effect is unambiguous: It is always negative!

18. Managerial Economics, Lecture 8: Deriving Demand Curves
Income Effect
An increase in the price of Good A reduces a consumers' buying power, thereby reducing his or her real income.
A change in real income is equivalent to a change in money income holding prices constant, so
The direction of the income effect depends on the income elasticity of Good A

19. Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects
price rise
substitution effect
income effect
normal good
negative
inferior good
positive

20. Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.5 Substitution and Income Effects with Normal Goods
Wine, Gallons
per year
12.0 L 2 L 1
5.5 e 2 L * I 2 e 1 e * I 1
26.7
30.6
58.9
Beer, Gallons per year
Substitution
Income effect
effect
Total effect

21. Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects with an Inferior Good
The substitution effect and the price change still have opposite signs.
The income effect and the price change have the same signs.
A Giffen good: good for which a decrease in its price causes the quantity demanded to fall (because the positive income effect is so large!)

22. Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.6 Giffen Good
Basketball,
Tickets per year L 2 L 1 e 2 L * I 2 e 1 e * I 1
Total effect
Substitution effect
Movies, Tickets per year
Income effect

23. Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects: Lessons
Income and substitution effects help identify consumer’s responses to changes in prices.
As we will see next time, they are very useful in predicting consumer’s responses to government programs that alter prices (as many do!).