PPA 723: Managerial Economics Lecture 8: Deriving Demand Curves

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


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.


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


D1, Demand for beer

Price-consumption curve

Wine, Gallons per year

(a) Indifference Curves and Budget Constraints

(b) Demand Curve


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.


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.


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.


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.


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


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



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


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


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.


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


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.


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


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!


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


Income and Substitution Effects

price rise substitution effect

income effect

normal good negative negative

inferior good negative positive


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


I 2

I1

L*

L2

L1

e2

e1

e *


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!)


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


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!).

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PPA 723: Managerial Economics Lecture 8: Deriving Demand Curves