7/31/2019 Econ Notes 1 http://slidepdf.com/reader/full/econ-notes-1 1/28 EC10C Lecture Notes Unit 3 Part 3 In this section of the Lecture Notes we look at the : 1. Income Consumption Curve and the Engel Curve. 2. Price Consumption Curve and the Derivation of the Demand Curve from the Price Consumption Curve. 3. Decomposition of the Total Price Effect in to the Income and Substitution Effects for the cases of Normal, Inferior and Giffen goods. 4. The difference between individual demand and market demand.
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7/31/2019 Econ Notes 1
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EC10C Lecture Notes Unit 3 Part 3
In this section of the Lecture Notes we look at the :
1. Income Consumption Curve and the Engel Curve.
2. Price Consumption Curve and the Derivation of the DemandCurve from the Price Consumption Curve.
3. Decomposition of the Total Price Effect in to the Income andSubstitution Effects for the cases of Normal, Inferior and Giffengoods.
4. The difference between individual demand and market demand.
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The Theory of the Consumer (Cont’d)
The Income Consumption Curve
This curve shows the different consumer equilibria which result aswe change the consumer’s income while holding the prices of the
two goods constant.
Good Y
Good X0
The IncomeConsumptionCurve
BL 1 BL 2 BL 3
IC 1
IC 2
IC 3
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The Theory of the Consumer (Cont’d)
The Engel Curve can be derived from the points alongthe Income Consumption Curve.
The Engel curve shows the relationship between theamount of the good that is bought and income.
The Engel curve for normal goods is upward slopingwhich denotes a positive relationship between demandfor the good and income.
The Engel curve for an inferior good is downward slopingwhich means that if income increases, then the demandfor that good falls and vice versa.
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The Theory of the Consumer (Cont’d)
Panel A shows the Engel curve for a normal good, while panel B showsthe Engel curve for an inferior good.
0 0
Income Income
(A) Normal Good (B) Inferior Good
Good X orGood Y
EngelCurve
EngelCurve
Good X orGood Y
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The Theory of the Consumer (Cont’d)
The Price Consumption Curve
This curve shows the different consumer equilibria which result as wechange one of the prices (the price of good X) while holding income andthe price of the other good (good Y) constant.
Good Y
The PriceConsumptionCurve
Good XBL1
BL2
BL3
IC 1
IC 2
IC 3
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The Theory of the Consumer (Cont’d)
We can derive the demand curve from the points alongthe price consumption curve.
The higher prices along the demand curve correspond tothe tangency points which are closer to the point of originon the graph showing the price consumption curve andthe various consumer equilibria.
The following graph shows this derivation:
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The Theory of the Consumer (Cont’d)
0
Good Y
The PriceConsumption Curve
Good XBL 1 BL 2 BL 3
IC 1
IC 2
IC 3
0
0
P1
Price
Quantity
Demanded
P2
P3
X1 X2 X3
DemandCurve
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The Theory of the Consumer (Cont’d)
The Decomposition of the Total Price Effect (TPE)
The Income and Substitution Effects Revisited
The Income effect is the change in the purchasing power ofincome (or real income) that occurs when the price of oneof the good changes.
The Substitution effect occurs when the change in price ofone of the goods (while holding the other good’s price and
income constant) results in a change in the quantity that isdemanded of that good whose price changed.
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The Theory of the Consumer (Cont’d)
We will break up the total price effect (TPE) into the substitution andincome effects. Thus TPE = SE + IE
The substitution effect (SE) is always negative. This means that theprice of a good and the quantity that is consumed of it (or bought) willalways move in opposite directions.
Normal Goods: The income effect (IE) is positive for normal goods. Thismeans that an increase in real income (or purchasing power) will
increase the amount of that good which is bought.
Inferior Goods: The income effect is always negative for inferior goods.This means that an increase in real income (or purchasing power) willreduce the amount of the good that is bought.
1. For normal goods, the substitution effect is reinforcedby the income effect. In other words, the SE and IE havethe same impact on the quantity of the good that is bought.
2. For inferior goods, the substitution effect will be largerthan the income effect, i.e. SE > IE.
3. For Giffen goods, the income effect is larger than thesubstitution effect, i.e. IE > SE.
We will break down the total price effect for all three typesof goods when the price of good X decreases.
Our initial consumer equilibrium is at 1, where the originalbudget line AB forms a tangent to the indifference curve IC
1. A decrease in the price of the good X will mean that moreof that good can be purchased.
The move from 1 to 2 is the substitution effect. The
substitution effect is shown by dashed budget line A’B’,which holds real income (purchasing power) constant. Thebudget line A’B’ keeps us on the same indifference curve IC
1. The substitution effect says that if the price of a good fallsthen persons will switch to consuming more that good.
The move from 2 to 3 is the income effect. The budget line
AC does not hold purchasing power constant. The incomeeffect is where the decrease in price increases thepurchasing power of the consumer. This increase inpurchasing power means that the consumer can now move
to a higher indifference curve IC 2 and budget line AC, andconsume more of the good.
The total price effect is the move from 1 to 3, which is the
The original equilibrium is at 1, where the budget line ABforms a tangent to the indifference curve IC 1.
The substitution effect is from 1 to 2 and the dashed budget
line A’B’ keeps real income constant. Although it is aninferior good, the substitution effect will mean that thedecrease in price will still result in an increase in quantitydemanded.
The move from 2 to 3 is the income effect. Although the
price has decreased and real income has increased, there isa reduction in the quantity consumed of the inferior gooddue to the negative income effect.
The income effect is dominated by the substitution effectand so the decrease in the price of the good will have thetotal price effect of an increase in the quantity that isconsumed of the inferior good.
The initial equilibrium is at 1, where the budget line ABforms a tangent to the indifference curve IC 1. The
substitution effect is from 1 to 2. The real income is heldconstant with the dashed budget line A’B’ and the same
indifference curve IC 1.
The income effect is from 2 to 3. The income effect isnegative for the Giffen good. The increase in real incomefrom the decrease in price will reduce the demand for theGiffen good.