PPA 723: Managerial Economics Lecture 8: Deriving Demand Curves
Dec 22, 2015
PPA 723: Managerial Economics
Lecture 8:
Deriving Demand Curves
Managerial Economics, Lecture 8: Deriving Demand Curves
Outline
Deriving Demand Curves
Income Elasticities of Demand
Income and Substitution Effects
Managerial Economics, Lecture 8: Deriving Demand Curves
Deriving Demand CurvesTrace out the demand curve for Good B
from a household-maximization diagram byholding income and the price of Good A
constantand varying the price of Good B
Then plot the price-quantity pairs in a new graph.
Managerial Economics, Lecture 8: Deriving Demand Curves
Pulling Out Price and Quantity Combinations
B, Burritosper semester
Price of Pizza Doubles
50
L 1 (p Z = $1)
L2 (pZ = $2)
25
250
Z, Pizzas per semester
2715
Price-ConsumptionCurve
Managerial EconomicsDeriving Demand Curves
Figure 5.1 Derivingan Individual’sDemand Curve
4.3
5.2
12.0
2.8
12.0
6.0
4.0
26.70 44.5 58.9
L1 (pb = $12)
pb, $ per unit
L2 (pb = $6) L3 (pb = $4)
26.70 44.5 58.9
e3
e2
e1
E3
E2
E1
I 1
I2
I 3
Beer, Gallons per year
Beer, Gallons per year
D1, Demand for beer
Price-consumption curve
Wine, Gallons per year
(a) Indifference Curves and Budget Constraints
(b) Demand Curve
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 causesmovement along the income-
consumption curve,shift of the demand curve,movement along the Engel curve.
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.
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.
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.
Managerial Economics, Lecture 8: Deriving Demand Curves
B, Burritosper semester
Income Doubles
100
L3 (Y = $100)
L1 (Y = $50)
50
25
500
Z, Pizzas per semester
25 55
Income-ConsumptionCurve
Pulling Out Income and Quantity Combinations
Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.2 Effect of a Budget Increase on an Individual’s Demand Curve
per year
Income-consumptioncurve
Engel curve for beer
0
2.8
4.8
7.1
49.138.226.7 Beer, Gallons per year
0
12
0
49.138.226.7 Beer, Gallons per year
49.138.226.7 Beer, Gallons per year
I2I 3
I 1
(a) Indifference Curves and Budget Constraints
Price of beer,$ per unit
(b) Demand Curves
Y, Budget (c) Engel Curve
e2
e3
E3E 1 E2
Y1 = $419
Y2 = $628
Y3 = $837
L3
L2
L1
e1
D 1D 2D 3
E1*
E2*
E3*
Wine, Gallons
Managerial Economics, Lecture 8: Deriving Demand Curves
Income ElasticitiesIncome elasticity:
Normal good: > 0Inferior good: 0Note: is Greek xi (pronounced ks-eye).
percentage change in quantity demanded
percentage change in income
/
/
Q Q
Y Y
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.
Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.3 Income-Consumption Curves and Income ElasticitiesHousing, Square feet
per year
Food, Pounds per year
Food normal,housing normal
Food inferior,housing normal
Food normal,housing inferior
b
c
e
a
L1
L2
I
ICC 2
ICC 1
ICC 3
Managerial Economics, Lecture 8: Deriving Demand Curves
Applications to PolicyPolicy 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 whenthey receive a cash grantincomes in general rise.
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
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!
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
Managerial Economics, Lecture 8: Deriving Demand Curves
Income and Substitution Effects
price rise substitution effect
income effect
normal good negative negative
inferior good negative positive
Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.5 Substitution and Income Effects with Normal GoodsWine, Gallons
per year
12.0
5.5
0 58.926.7 30.6Substitution
effectTotal effect
Income effect
Beer, Gallons per year
I 2
I1
L*
L2
L1
e2
e1
e *
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!)
Managerial Economics, Lecture 8: Deriving Demand Curves
Figure 5.6 Giffen GoodBasketball,
Tickets per year
Movies, Tickets per year
L1
L*
Total effect
Income effect
Substitution effect
L2
e1
e2
e*
I 1
I 2
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!).