ECON 339: consumer demand 1
Consumer demand
ECON 339: consumer demand 2
Consumer demand
• Consumer equilibrium: choice of optimal bundle given income and prices – that is, given the budget set
• What happens if the budget set changes? – What causes changes in budget set?
• i)Change in income, holding prices constant
• ii) Change in one price, holding other price and income constant
• iii) Change in both prices?
• iv) Change in one price, and income?
ECON 339: consumer demand 3
i) Income effects
• Why does optimal bundle change in response to change in income?
• Recall: given “rationality”, maximizing utility requires spending all income – consuming at a point on the BL
• If income , with prices constant – BL shifts to the right – Points formerly on BL now strictly interior
– Former choice no longer the best
• How does composition of optimal bundle change?
ECON 339: consumer demand 4
Normal and inferior goods
• What changes to optimal bundle are possible?
• Both goods increase?
• One increases, other decreases?
• Both decrease?
• Conclusion: consumption of at least one good must increase in response to increase in income.
• Alternative phrasing: “at least one good must be normal”
• Alternative to normal good? Inferior good: quantity decreases in response to increase in
income, with prices constant
ECON 339: consumer demand 5
Income expansion path, Engel curves • Income expansion path:
– In goods (x,y) space – Curve joining optimal consumption bundles as income varies,
with prices constant – Slope reflects type of goods
• Both normal • One normal, one inferior
• Engel curve:
– In (good, income) space – plots consumption path of a particular good as income varies – Slope reflects sign of income elasticity:
– Normal good vs Inferior good
– Luxuries (income elastic) vs necessities (income-inelastic)
% %
q Y q Y q Y ∆ ∂
= ∆ ∂
ECON 339: consumer demand 6
ii) Price effects
• With 2 goods, have “own-price” effects, and “cross-price effects” – As with changes in income, quantities change because budget set
changes when one or more prices change.
• A) Own price effects:
– Holding constant income and other price(s), how does quantity demanded of one good change as its price changes?
– Properties of the demand curve for this good
– Def’n of demand curve? • Quantity demanded of a good, at each price of that good,
holding income and other prices fixed.
ECON 339: consumer demand 7
Own price effects
• Consider following experiment: 1. Initial budget set {Y, pf′, po′} – consumer chooses bundle A = – conditions satisfied by this bundle? 2. Price of food decreases to pf″ < pf ′, with income and price of other
goods constant – new budget set defined by {Y, pf″, po′} – consumer chooses bundle B = – conditions satisfied by this bundle?
ECON 339: consumer demand 8
Income and substitution effects • What has happened to budget set as price falls?
– increased in size: original optimal bundle now interior – slope of BL changed: – at original optimal bundle, no longer true that MRS = price
ratio – both these changes will alter optimal bundle – to analyse total effect, we disentangle theminto separate effects: – income effect: change in size of budget set – substitution effect: change in relative prices
ECON 339: consumer demand 9
Income & substitution effects • Given: A is original bundle, B is new • Substitution Effect: • Consider point C: on original IC (through A) where
MRS = new price ratio – Consumer indifferent between A and C – since give same utility level, “choice” between them based on
relative prices
– Movement from A to C represents substitution effect – change in quantities purchased due to changes in relative prices, with utility held constant.
– sign of subst’n effect? – decrease in unit price of food, all else constant, means relative price of food falls → substitute towards food → Δq/Δp < 0
ECON 339: consumer demand 10
Income & subst’n effects • Income Effect:
– Movement from C, on original IC, to B (optimal bundle with new prices)
– same relative price, B on higher IC – response to budget set expansion
– Sign of income effect? Depends:
• normal good • inferior good
• Net effect: Income plus substitution effect
– Slope of demand curve • Normal good: • Inferior good:
ECON 339: consumer demand 11
Cross price effects
• Change in quantity of one good in response to change in price of other good, all else constant
• In general….?
• Disaggregate into income & subst’n effects: – with 2 goods, subst’n effect: – income effect? • Complements and substitutes
ECON 339: consumer demand 12
iii) Changes in both prices?
• Change both prices, holding income constant: – Shift both slope and position of BL
• proportional change (both prices increase by 10%)? • Different increases (food up by 5%, other goods up by 2%)
• Changes in both prices and income, in same proportion
(eg, both prices and income increase by 10%) – Budget set unchanged
Consumer demand
Consumer demand
i) Income effects
Normal and inferior goods
Income expansion path, Engel curves
ii) Price effects
Own price effects
Income and substitution effects
Income & substitution effects
Income & subst’n effects
Cross price effects
iii) Changes in both prices?
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