1. Demand and Behavior in Markets
Chapter 4
Demand and Behavior
in Markets

2. The Problem of Consumer Choice
Maximize utility
Indifference curve tangent to budget line
MRS = price ratio
On budget line
Quantity demanded of a good
People seek to purchase at a given price

3. Optimal consumption bundle
Good 2 (x 2) 20 B B’ I1 I2 I3 e
x1 + x2 = 20 F
Good 1 (x 1) 20

4. Demand is homogenous
If income and all prices double, the quantity demanded of all goods remains the same
Reason: same budget constraint

5. Changes in Income When income only increases, Show graphically
Normal good: demand for goods increases
Inferior good: demand decreases, e.g. used clothes, bus tickets,..
Show graphically

6. Superior and inferior goods
Good 2 (x 2)
(a)
(b)
Good 2 (x 2)
Good 1 (x 1)
Good 1 (x 1)

7. Homothetic Preferences
Indifference curves
Do not “rotate” as consumer’s income increases
Along any ray from the origin
MRS – constant
Increase in income
Proportional increase in goods purchased
All goods are superior
No change in tastes

8. Good 2 (x 2) 60 40 20 D D’
Income expansion path C C’ s B B’ r e
Good 1 (x 1) 60 40 20

9. Price-Consumption Paths
Price-consumption path / curve
Consumption changes
One price changes
All other prices – constant
Consumer’s income – constant

10. Effects of Price changes on budget
Changing relative prices
Optimal bundle
Indifference curve tangent to budget line
MRS = Price ratio
Good 1 – relatively less expensive
Rotation of budget line – flatter
Good 1 – relatively more expensive
Rotation of budget line – steeper

11. Good 2 (x 2) B B’ B* B” g e c f b a
Good 1 (x 1)
As the price of good 1 varies, the slope of the budget line changes leading to different levels of consumption

12. Demand Curves Demand curve Relationship between
Quantity demanded
Price
As the price varies
Other things constant
Image of the price-consumption path
Generated: utility-maximizing behavior

13. Demand curve for good1 Price p1=2 a p1=1 b p1=1/2 c Good 1 (x 1)
The demand curve for good 1 associates the optimal quantity of good 1 with its price, while holding income and other prices constant.

14. Demand and Utility Functions
Nonconvex preferences
Optimal consumption bundle
At the corner of the feasible set
Maximize utility
Spend all income on only one good
Demand curve
If price > p*, quantity = 0
If price = p*, quantity > 0
As price decreases, quantity increases

15. X1=m/p1 Non convex preferences and demand (a) (b) Price Good 2 (x 2) Bh g* p* e k
Good 1 (x 1)
Good 1 (x 1)
Non-convex preferences imply optimal consumption bundles at the corners of the feasible set—either point h or point k.
Demand curve.
Non-convex preferences imply jumps in the demand curve.

16. Decomposing the Effects of a Price Change
Substitution Effect: change in consumption caused by a change in relative prices
Income Effect: change in consumption as a result of a change in the budget set

17. Substitution Effect Change in demand due to substitution
One good (decreasing price)
For another good (constant price)
The substitution effect from the decline in price always increases demand

18. Income Effect Income effect
Decrease in price is equivalent to an increase in real income
The income effect from the decline in price will cause demand to
Increase if the good is normal
Decrease if the good is inferior

19. (a) (b) Good 2 (x 2) Price B’ B B” I2 p’ I1 D’ D e e f p” g f p” p’
Substitution effect
Income effect
Good 1 (x 1)
Good 1 (x 1)
The income effect of the price change is measured by the parallel shift of the budget line from DD’ to BB”. The substitution effect is measured by movement around the indifference curve from e to g.
Downward-sloping demand curve

20. How does the demand curve for good 1 look like?
Inferior Goods: Income and substitution effects work on opposite directions
Good 2 (x 2)
How does the demand curve for good 1 look like? I2 B’ B B” f I1 D’ D e
Substitution
effect g
Income effect
Good 1 (x 1)
The substitution effect of a decline in the price of good 1 causes an increase in demand for the good, the move from e to g. Because good 1 is an inferior good, this is partly offset by the income effect, a decrease in demand for the good from g to f .

21. Giffen Goods and Upward-Sloping Demand Curves
Upper sloping demand curve
Inferior good
A price decrease
Substitution effect
Increase demand
Income effect
Decrease demand
Dominant effect: income effect

22. Giffen good Good 2 (x 2) B f I2 Income effect Substitution effect D e
The decline in the price of good 1 causes a decline in the demand for that good because the substitution effect (the move from e to g) is more than offset by the income effect (the move from g to f ).

23. Identifying normal and Giffen goods
Type of good
Substitution effect
Income effect
Normal downward sloping D
Opposite to price change
The good is either superior or inferior
but with an income effect that is less
powerful than the substitution effect.
Giffen Upward sloping D
The good is inferior.
The income effect is more powerful
than the substitution effect.

24. Good 2 (x 2) 20 g e 18 f 15 8
Good 1 (x 1) 10 20 40