Ch03. Individual Demand Curves

Chapter 3
Individual
Demand
Curves
© 2004 Thomson Learning/South-Western

Individual Demand Curves
 This chapter studies how people change their

choices when conditions such as income or
changes in the prices of goods affect the
amount that people choose to consume.
 This chapter then compares the new choices
with those that were made before conditions
changed
 The main result of this approach is to construct
an individual’s demand curve
2
Demand Functions
 If we knew a person’s preferences and all the

economic forces that affect his or her choices,
we could predict how much of each good
would be chosen.
 This summarizes this information in a demand
function: a representation of how quantity
demanded depends on prices, income, and
preferences.
3
Demand Function
Quantity of X demanded  d x ( PX , PY , I ; preferences)
 The three elements that determine the quantity

demanded are the prices of X and Y, the
person’s income (I), and the person’s
preferences for X and Y.
 Preferences appear to the right of the semicolon
because we assume that preferences do not
change during the analysis.
4
Homogeneous Demand Function
 Individual demand functions are homogeneous

since quantity demanded does not change
when prices and income increase in the same
proportion.
 The budget constraint PXX + PYY = I is
identical to the budget constraint 2PXX + 2PYY
= 2I.
 Graphically the lines are the same.
5
Changes in Income
 When a person’s income increase, while prices

remain the same, the quantity purchased of
each good might increase.
 This situation is shown in Figure 3.1 where the
increase in income is shown as the budget line
shifts out from I1 to I2 to I3.
 The slope of the budget lines are the same
since the prices have not changed .
6
FIGURE 3.1: Effect of Increasing Income on
Quantities of X and Y Chosen
Quantity of Y
per week
Y1
U1
I1
0 X1 Quantity of X
7 per week
Quantity of Y
per week
Y2
Y1 U2
U1
I1 I2
0 X1 X2 Quantity of X
8 per week
Quantity of Y
per week
Y3
Y2 U3
Y1 U2
U1
I1 I2 I3
0 X1 X2 X3 Quantity of X
9 per week
Changes in Income
 In response to the increase in income the

quantity of X purchased increases from X1 to
X2 and X3 while the quantity purchased of Y
also increases from Y1 to Y2 to Y3.
 Increases in income make it possible for a
person to consume more reflected in the
outward shift in the budget constraint that
allows an increase in overall utility.
10
Normal Goods
 A normal good is one that is bought in greater

quantities as income increases.
 If the quantity increases more rapidly than
income the good is called a luxury good as with
good Y in Figure 3.1.
 If the quantity increases less rapidly than
income the good is called a necessity good as
with good X in Figure 3.1.
11
APPLICATION 3.1: Engel’s Law
 One important generalization about consumer

behavior is that the fraction of income spent on
food tends to decline as income increases.
 This finding was discovered by Prussian
economists Ernst Engel (1821-1896).
 Table 1 show Engel’s data with Table 2
showing recent data for U.S. consumers.
12
TABLE 1: Percentage of Total Expenditures of
Various Items in Belgian Families in 1853
Annual Income
Expenditure Item $225-$300 $450-$600 $750-$1000
Food 62.0% 55.0% 50.0%
Clothing 16.0 18.0 18.0
Lodging, light, and fuel 17.0 17.0 17.0
Services (education, legal, health) 4.0 7.5 11.5
Comfort and recreation 1.0 2.5 3.5
Total 100.0 100.0 100.0
13
TABLE 2: Percentage of Total Expenditures
by U.S. Consumers on Various Items, 2000
Annual Income (000)

Item $15 - 20 $40 - 50 $70+
Food 15.4% 14.7% 11.4%
Clothing 4.8 4.7 5.3
Housing 32.9 30.4 30.2
Other Items 46.9 50.2 53.1
Total 100.0 100.0 100.0
14
Inferior Goods
 An inferior good is one that is bought in smaller

quantities as income increases.
 In Figure 3.2 as income increases from I1 to I2
to I3, the consumption of inferior good Z
decreases.
 Goods such as “rotgut” whiskey, potatoes, and
secondhand clothing are examples of inferior
goods.
15
FIGURE 3.2: Indifference Curve Map
Showing Inferiority
Quantity of Y
per week
Y1 U1
0 Z1 I1 Quantity of Z
16 per week
Showing Inferiority
Quantity of Y
per week
Y2
U2
Y1 U1
I1 I2
0 Z2 Z1 Quantity of Z
17 per week
Showing Inferiority
Quantity of Y
per week
Y3
U3
Y2
U2
Y1 U1
I1 I2 I3
0 Z3 Z2 Z1 Quantity of Z
18 per week
Changes in a Good’s Price
 A change in the price of one good causes both

the slope and an intercept of the budget line to
change.
 The change also involves moving to a new
utility-maximizing choice on another
indifference curve with a different MRS.
 The quantity demanded of the good whose
price has changed changes.
19
Substitution Effect
 The part of the change in quantity demanded

that is caused by substitution of one good for
another is called the substitution effect.
 This results in a movement along an
indifference curve.
 Consumption has to be changed to equate
MRS to the new price ratio of the two goods.
20
Income Effect
 The part of the change in quantity demanded

that is caused by a change in real income is
called the income effect.
 The price change also changes “real”
purchasing power and consumers will move to
a new indifference curve that is consistent with
this new purchasing power.
21
Substitution and Income Effects
from a Fall in Price
 As shown in Figure 3.3, when the price of good

X falls, the budget line rotates out from the
unchanged Y axis so that the X intercept lies
father out because the consumer can now buy
more X with the lower price.
 The flatter slope means that the relative price
of X to Y (PX/PY) has fallen.
22
Substitution Effect from a Fall in
Price
 The consumer was originally maximizing utility

at X*, Y* in Figure 3.3.
 After the fall in the price of good X, the new
utility maximizing choice is X**, Y**.
 The substitution effect is the movement on the
original indifference curve to point B.
23
FIGURE 3.3: Income and Substitution
Effects of a Fall in Price
Quantity of Y
per week
Y*
U1
0 X* Quantity of X
per week
24
Quantity of Y
per week
Old budget constraint

Y*
B
New budget constraint
U1
0 X* XB Quantity of X
Substitution per week
25 effect
Quantity of Y
per week
Y** Old budget constraint

Y* U2
B
U1
0 X* XB X** Quantity of X
per week
Substitution Income
effect effect
26 Total increase in X
Substitution Effect from a Fall in
Price
 If the individual had to stay on the U1 with the

new price ratio, the consumer would choose B
since that is the point where the MRS is equal
to the slope of the new budget line (shown by
the dashed line).
 Staying on the same indifference curve is the
same as holding “real” income constant.
 The consumer buys more good X.
27
Income Effect
 The movement from point B to X**, Y** results

from the increase in purchasing power.
 Because PX falls but nominal income (I)
remains the same, the individual’s “real”
income increases so that he or she can be on
utility level U3.
 The consumer buys more good X.
28
The Effects Combined
 Using the hamburger-soft drink example from

Chapter 2, suppose the price of soft drinks falls
from $.50 to $.25.
 Previously the consumer could purchase up to
20 soft drinks, but now he or she can purchase
up to 40.
 This price decrease shifts the budget line
outward and increases utility.
29
 If the consumer bought his or her previous

choice it would now cost $7.50 so that $2.50
would be unspent.
 If the individual stayed on the old indifference
curve he or she would equate MRS to the new
price ratio (consuming 1 hamburger and 4 soft
drinks).
 This move is the substitution effect.
30
 Even with constant real income the consumer

will buy more soft drinks since the opportunity
cost of eating a burger in terms of the soft
drinks forgone is now higher.
 Since real income has increased the person
will choose to buy more soft drinks so long as
soft drinks are a normal good.
31
from an Increase in Price
 An increase in PX will shift the budget line in as

shown in Figure 3.4.
 The substitution effect, holding “real” income
constant, is the move on U2 from X*, Y* to point
B.
 Because the higher price causes purchasing
power to decrease, the movement from B to
X**, Y** is the income effect.
32
Effects of an Increase in Price
Quantity of Y U2
per week

Y*
0 X* Quantity of X
per week
33
Quantity of Y U2
per week
U1 B

Y*
0 XB X* Quantity of X
Substitution per week
34 effect
Quantity of Y U2
per week
U1 B
Y**
Y*
0 X** XB X* Quantity of X
per week
Income Substitution
effect effect
Total reduction
35 in X
from an Increase in Price
 In Figure 3.4, both the substitution and income

effects cause the individual to purchase less
soft drinks do to the higher price of soft drinks.
36
Substitution and Income Effects for
a Normal Good: Summary
 As shown in Figures 3.3 and 3.4, the

substitution and income effects work in the
same direction with a normal good.
 When the price falls, both the substitution and
income effects result in more purchased.
 When the price increases, both the
substitution and income effects result in less
purchased.
37
 This provides the rational for drawing

downward sloping demand curves.
 This also helps to determine the steepness of
the demand curve.
 If either the substitution or income effects are
large, the change in quantity demanded will be
large with a given price change.
38
 If the substitution and income effects are small,

the effect of a given price change in the
quantity demanded will also be small.
 This kind of analysis also offers a number of
insights about some commonly used economic
statistics.
39
APPLICATION 3.2: The Consumer Price
Index and Its Biases
 The Bureau of Labor Statistics monthly

calculates the Consumer Price Index (CPI)
which is a principal measure of inflation in the
U.S..
 To construct the CPI, a typical market basket of
commodities purchased by consumers in the
base year (currently 1982) is calculated.
40
APPLICATION 3.2: The Consumer Price
Index and Its Biases
 The ratio of the current cost of the basket to

the base year price is the measure of the value
of the CPI.
 The rate of change in the CPI between two
periods is the reported rate of inflation.
41
An Algebraic Example
 Suppose the 1982 typical market basket

contained X82 of good X and Y82 of good Y.
 The prices of these goods are PX82 and PY82 .
 The cost of this bundle in the 1982 base year
would be written as
Cost of bundle in 1982 
B P X
82 82
X
82
 P Y .
Y
82 82
42
 To compute the cost of the same bundle of

goods in, say 2002, requires that we compute
the cost of the bundle using current prices
( PX02 , PY02 )
Cost of bundle in 2002 
B  P  X 82  P  Y82 .
02 02
X Y
02
43
 The CPI is defined as the ratio of the costs of

these two market baskets
B 02
CPI(for 2002)  82 .
B
 If the basket cost $100 in 1982 prices and
$180 in 2002, the value of the CPI would be
1.80 and with a measured 80 percent increase
in prices over the 20 year period.
44
Substitution Bias in the CPI
 The CPI does not take into account the real

possibility that consumers would substitute
among commodities because of changes in
relative prices.
 In Figure 1, the typical individual is initially
consuming X82, Y82 maximizing utility on U1
with 1982 constraint I.
45
FIGURE 1: Substitution Bias of the
Consumer Price Index
Quantity of
Y per year
Y82
U1
I I” I’
0 X82 Quantity of
X per year
46
 Suppose the 2002 relative prices change so

that PX/PY falls.
 The cost of the 1982 bundle in terms of 2002
prices is reflected in the constraint I’ which is
flatter and goes though the 1982 bundle.
 The consumer would substitute X for Y and
stay on U1 on budget line I’’.
47
 Since I’’ is inside I’ (which is used to compute

the CPI), the CPI tends to overstate the
inflation rate.
 Unfortunately, adjusting the CPI to take such
substitution into account is difficult because it
would require that we know the utility function
of the typical consumer.
48
New Product Bias in the CPI
 New products typically experience sharp

declines in prices and rapidly grow in rates of
acceptance.
 If the CPI does not include these new products,
this source of welfare increase is omitted.
 The CPI basket is revised but not rapidly
enough to eliminate this bias.
49
Outlet Bias in the CPI
 The typical basket is bought at the same retail

outlets every month.
 This method can omit the benefits of sales or
other bargains.
 The CPI does not currently take such price-
reducing strategies and thus tends to overstate
inflation.
50
Consequences of the CPI Biases
 Measuring and correcting for these biases is

not an easy task.
 The CPI is such a widely used measure of
inflation that any change becomes a hot
political issue.
 However, there is a general agreement that the
CPI overstates inflation by as much as 0.75 to
1.0 percent per year.
51
Consequences of the CPI Biases
 Politicians have proposed caps on Cost of

Living Adjustments (COLAs) tied to the CPI on
government programs, but none have yet been
enacted.
 However, the private sector has adjusted so
that few private COLAs provide full offsets to
inflation measured by the CPI.
52
Inferior Goods
 With an inferior good, the substitution effect

and the income effects work in opposite
directions.
 The substitution effect results in decreased
consumption for a price increase and
increased consumption for a price decrease.
53
Inferior Goods
 The income effect results in increased

consumption for a price increase and
decreased consumption for a price decrease.
 Figure 3.5 shows the two effects for an
increase in PX.
 The substitution effect, holding real income
constant, is shown by the move from X*, Y* to
point B both on U2.
54
Effects for an Inferior Good
Quantity of Y
per week
Y*
U2
0 Quantity of X
X*
55 per week
Quantity of Y
per week

Y*
U2
Y**
U1
0 Quantity of X
56 X*
Quantity of Y
per week

Y*
U2
Y**
U1
0 Quantity of X
57 X** X*
Inferior Goods
 The income effect reflects the reduced

purchasing power due to the price increase.
 Since X is an inferior good, the decrease in
income results in an increase in the
consumption of X shown by the move from
point B on U1 to the new utility maximizing
point X**, Y** on U1.
58
Inferior Goods
 Since X** is less than X* the price increase in X

results in a decrease in the consumption of X.
 This occurs because the substitution effect, in
this example, is bigger than the income effect.
 Thus, if the substitution effect dominates, the
demand curve is negatively sloped.
59
Giffen’s Paradox
 If the income effect of a price change is strong

enough with an inferior good, it is possible for
the quantity demanded to change in the same
direction as the price change.
 Legend has it that this phenomenon was
observed by English economist Robert Giffen.
60
Giffen’s Paradox
 When the price of potatoes rose in Ireland the

consumption of potatoes also increased.
 Potatoes were not only an inferior good but
constituted the source of a large portion of Irish
people’s income.
 The situation I which an increase in a good’s
price leads people to consume more of the
good is called Giffen’s paradox.
61
The Lump Sum Principle
 The “lump-sum principle” hold that taxes that

are imposed on general purchasing power will
have a smaller welfare costs than will taxes
imposed on a narrow selection of commodities.
 Consider Figure 3.6 where the individual
initially has I dollars to spend and chooses to
consume X* and Y* yielding U3 utility.
62
FIGURE 3.6: The Lump-Sum Principle
Quantity of Y
Y*
U3
X* Quantity of X
63 per week
 A tax on only good X raises its price resulting in

budget constraint I’ and consumption reduced
to X1, Y1 and utility level U1.
 A general income tax that generates the same
total tax revenue is represented by budget
constraint I’’ that goes though X1, Y1.
64
Quantity of Y
Y1
Y* I’
Y2
U3
U1
X1 X* Quantity of X
65 per week
Quantity of Y
Y1
Y* I’ I”
Y2
U3
U2
U1
X1 X2 X* Quantity of X
66 per week
 The utility maximizing choice on I’’ is X2, Y2

yielding utility level U2.
 The lump-sum general income tax generates
the same amount of tax revenue but leaves the
consumer on a higher utility level (U2) than the
utility level associated with the tax only on
good X (U1).
67
 The intuitive explanation of the lump-sum

principle is that a single-commodity tax affects
people in two ways:
– it reduces their purchasing power,
– it directs consumption away from the good being
taxed.
 The lump-sum tax only has the first of these
two effects.
68
Generalizations of the Lump-Sum
Principle
 The utility lass associated with the need to

collect a certain amount of tax revenue will be
minimized by taxing goods for which the
substitution effect is small.
 Even though the tax will reduce purchasing
power, it will minimize the impact of directing
consumption away from the good being taxed.
69
APPLICATION 3.3: Wouldn’t Cash Be a
Better Way to Help Poor People?
 The lump-sum principle suggests that the

trends in expanding in-kind programs may be
unfortunate
 These programs do not generate as much
welfare for people as would the spending of the
same funds in a cash program
70
APPLICATION 3.3: Wouldn’t Cash Be a
Better Way to Help Poor People?
 In Figure 1 a subsidy on good X (constraint

I’) raises utility to U2
 For the same funds, an income grant (I’’)
raises utility to U3
71
FIGURE 1: The Superiority of an
Income Grant
Y per
period
I’’
U3
B I’
U2
I
U1
X per period
72
Changes in the Price of Another
Good
 When the price of one good changes, it usually

has an affect on the demand for the other
good.
 In Figure 3.3, the increase in the price of X (a
normal good) caused both an income and
substitution effect that caused a reduction in
the quantity demanded of X.
73
Good
 In addition, the substitution effect caused a

decrease in the demand for good Y as the
consumer substituted good X for good Y.
 However, the increase in purchasing power
brought about by the price decrease causes an
increase in the demand for good Y (also a
normal good).
74
Good
 Since, in this case, the income effect had a

dominant effect on good Y, the consumption of
Y increased due to a decrease in the price of
good X.
 With flatter indifference curves as shown in
Figure 3.7, the situation is reversed.
 A decrease in the price of good X causes a
decrease in good Y, as before.
75
FIGURE 3.7: Effect on the Demand for Good Y
of a Decrease in the Price of Good X
Quantity of Y
per week
Y*
U1
0 Quantity of X
X*
76 per week
FIGURE 3.7: Effect on the Demand for Good
Y of a Decrease in the Price of Good X
Quantity of Y
per week
A
Y*
B New budget constraint

U2
U1
0 Quantity of X
77 X*
per week
FIGURE 3.7: Effect on the Demand for Good
Y of a Decrease in the Price of Good X
Quantity of Y
per week
A
Y*
C
Y** B New budget constraint
U2
U1
0 Quantity of X
78 X* X**
per week
Good
 However, in this case, the income effect is

much smaller than the substitution effect so
that the consumer ends up consuming less of
good Y at Y** after the decrease in the price of
X.
 Thus, the effect of a change in the price of one
good has an ambiguous effect on the demand
for the other good.
79
Complements
 Complements are goods that go together in the

sense that people will increase their use of
both goods simultaneously.
 Two goods are complements if an increase in
the price of one causes a decrease in the
demanded of the other or a decrease in the
price of one good causes an increase in the
demand for the other.
80
Substitutes
 Substitutes are goods that are goods that are

used for essentially the same purpose.
 Two goods such that if the price of one
increases, the demand for the other rises are
substitutes.
 If the price of one good decreases and the
demand for the other good decreases, they are
also substitutes.
81
APPLICATION 3.4: Why Are So Many
“Trucks” on the Road?
 There has been a huge gain in truck registrations over

the past 10 years
 The Department of Transportation regards a wide
variety of automobile-like vehicles as “trucks” (like
vans, minivans, and SUVs)
 One of the most important reasons in the trend toward
SUVs has been a sharp decline in real gasoline prices
 There has been a substitution away from more
traditional automobiles.
82
Construction of Individual Demand
Curves
 An individual demand curve is a graphic

representation between the price of a good and
the quantity of it demanded by a person
holding all other factors (preferences, the
prices of other goods, and income) constant.
 Demand curves limit the study to the
relationship between the quantity demanded
and changes in the own price of the good.
83
Curves
 In Panel a of Figure 3.8 an individual’s

indifference curve map is drawn using three
different budget constraints in which the price
of X decreases.
 The decreasing prices are P’X, P”X, and P’’’X
respectively.
 The individual’s utility maximizing choices of X
are X’, X’, and X’’’ respectively.
84
FIGURE 3.8: Construction of an
Individual’s Demand Curve
Quantity of Y
per week Budget constraint for9P
X
U1
0 X’ Quantity of X
per week
(a) Individual’s indifference curve map
Price
P’X
0 X’ Quantity of X
85 (b) Demand curve
per week
Quantity of Y
per week
Budget constraint for P’X
Budget constraint for P’’X
U2
U1
0 X’ X” X’” Quantity of X
per week
Price
P’X
P’’X
0 X’ X” Quantity of X
86 (b) Demand curve
per week
Quantity of Y
per week
Budget constraint for P’’’X
U3
U2
U1
per week
Price
P9
X
P0
X
P-
X
87 (b) Demand curve
per week
Quantity of Y
per week
Budget constraint for P’’’X
U3
U2
U1
per week
Price
P9
X
P0
X
P-
X
d
X
88 (b) Demand curve
per week
Curves
 These three choices show that the quantity

demanded of X increases as the price of X
falls.
 Panel b shows how the three price and
quantity choices can be used to construct the
demand curve.
89
Curves
 The price of X is shown on the vertical axis and

the quantity of X is shown on the horizontal
axis.
 The demand curve (dX) is downward sloping
showing that when the price of X falls, the
quantity demanded of X increases.
 As previously shown, this result follows from
the substitution and income effects.
90
Shape of the Demand Curve
 If a good, say X, has close substitutes, a

increase in its price will cause a large decrease
in the quantity demanded as the substitution
effect will be large.
– The demand curve for a type of breakfast cereal will
likely be relatively flat due to the strong substitution
effect.
91
 If the good has few substitutes, the substitution

effect of a price increase or decrease will be
small and the demand curve will be relatively
steep.
– Water is an example of a good with few substitutes.
92
 Food has no substitutes so it might be thought

that no change in consumption would occur
with a price increase.
 But food constitutes a large part of an
individual’s budget so that price changes will
cause relatively larger effects on the quantity
demanded that might be thought due to the
income effect.
93
Shifts in an Individual’s Demand
Curve
 When one of the variables that are held

constant (price of another good, income or
preferences) on a demand curve changes, the
entire curve shifts.
 Figure 3.9 shows the kinds of shifts that might
take place.
 If X is a normal good and income increases,
demand increases as shown in Panel a.
94
FIGURE 3.9: Shifts in Individual’s
Demand Curve
PX PX PX
P1 P1
P1
X1 X2 X X1 X2 X X2 X1 X
0 0 0
(a) (b) (c)
95
FIGURE 3.9: Shifts in Individual’s
Demand Curve
PX PX PX
P1 P1
P1
X1 X2 X X1 X2 X X2 X1 X
0 0 0
(a) (b) (c)
96
Curve
 If X and Y are substitutes and the price of Y

increases, the demand for X increases as
shown in Panel b.
 Alternatively, if X and Y are complements, the
increase in the price of Y will cause a decrease
in the demand for X as shown in Panel c.
97
Curve
 Changes in preferences can also shift demand

curves.
 Panel b could represent an increased
preference for cold drinks when a sudden hot
spell occurs.
 Increased environmental consciousness during
the 1980’s and 1990s increased the demand
for recycling and organic food.
98
APPLICATION 3.5: Fads, Seasons, and
Health Scares
 Fads (sometimes termed bandwagon effects)

are when preferences cause extremely large
increases in demand followed later by large
decreases in demand.
 While fads are hard to predict, seasonal items
are easy to predict.
– Increased demand for turkeys in November and
Christmas trees are examples.
99
APPLICATION 3.5: Fads, Seasons, and
Health Scares
 Health scares can cause large decreases in

the demand for products.
– Examples include the long term decline in smoking
and the decreased demand for Chinese food
because of the concern for its fat content.
 Recent “scientific” studies have also affected
demand such as the increase in the demand
for tomatoes in 1998.
100
Be Careful in Using Terminology
 A movement downward along a stationary

demand curve in response to a fall in price is
called an increase in quantity demanded
while a rise in the price of the good results in a
decrease in quantity demanded.
 A rightward shift in a demand curve is called an
increase in demand while a leftward shift is a
decrease in demand.
101
Consumer Surplus
 The extra value individuals receive from

consuming a good over what they pay for it is
called consumer surplus.
 Consumer surplus is also what people would
be willing to pay for the right to consume a
good at its current price.
 This concept is used to study the welfare
effects of price changes.
102
Consumer Surplus
 The demand curve for T-shirts is shown in

Figure 3.10.
 At the price of $11 the individual chooses to
consume ten T-shirts.
 In other words, the individual is willing to pay
$11 for the tenth T-shirt that they buy.
 With a price of $9, the individual chooses
fifteen T-shirts, so implicitly they value the
fifteenth shirt at only $9.
103
Consumer Surplus
 Because a good is usually sold at a single

market price, people choose to buy additional
units of the good up to the point at which their
marginal valuation is equal to the price.
 In Figure 3.10, if T-shirts sell for $7, the
individual will buy twenty shirts because the
twentieth T-shirt is worth precisely $7.
 They will not buy the twenty-first T-shirt
because it is worth less than $7.
104
Consumer Surplus
 Because the individual would be willing to pay

more than $7 for the tenth or fifteenth T-shirt, it
is clear that they get a “surplus” on those shirts
because the individual is actually paying less
than the maximal amount that they would be
willing to pay.
 Consumer surplus is the difference between
the maximal amounts a person would pay for a
good and what he or she actually pays.
105
Consumer Surplus
 In graphical terms, consumer

surplus is given by the area below
the demand curve and above the
market price.
 In Figure 3.10, total consumer surplus
is given by area AEB ($80).
106
FIGURE 3.10: Consumer Surplus from T-
Shirt Demand Price ($/shirt)
Price
($/shirt)
15 A
11
9
E
B d
Quantity
10 15 20 (shirts)
107
Consumer Surplus and Utility
 Figure 3.11 illustrates the connection

between consumer surplus and utility
 Initially, the person is at E with utility U1.
 He or she would need to be compensated
by amount AB in other goods to get U1 if
T-shirts were not available.
108
Consumer Surplus and Utility
 In Figure 3.11, the individual would be

willing to pay BC for the right to consume
T-shirts rather than spending I only on
other goods.
 Both distance AB and BC approximate the
consumer surplus area in Figure 3.10.
109
FIGURE 3.11: Consumer Surplus
and Utility
Price ($/shirt)
C
E
U1
I
U0
I’
Quantity
20 (shirts)
110
APPLICATION 3.6: Valuing Clean Air
 By looking at the ceteris paribus relationship

between air pollution levels in various locations
and the prices of houses in these locations, it is
possible to infer the amount that people will
pay to avoid dirty air.
 This information allows the computation of a
compensated demand curve for clean air.
111
 In Figure 1, the vertical axis shows the price

home buyers are willing to pay to avoid air
pollution and the horizontal axis shows the
quantity of clean air purchased.
 The national average is reflected at point E as
home buyers pay $50 and consume an
average of 55 micrograms of suspended
particulates per cubic meter.
112
FIGURE 1: Compensated Demand Curve
for Clean Air
Price
($)
85
80
60
50 E
40
20
D
100 75 50 25 0 Air quality
(mg/m3)
55
113
 Consumers are paying $2,250 ($50 times 45

micrograms) extra to avoid dirty air.
 At E0 consumers also receive a consumer
surplus equal to the shaded area in Figure 1.
 This consumer surplus of 788 per household
can be multiplied by the total number of
households to estimate total consumer surplus
from clean air.
114

Ch03. Individual Demand Curves

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Ch03. Individual Demand Curves

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Chapter 3

© 2004 Thomson Learning/South-Western

 This chapter studies how people change their

 If we knew a person’s preferences and all the

Quantity of X demanded  d x ( PX , PY , I ; preferences)

 The three elements that determine the quantity

 Individual demand functions are homogeneous

 When a person’s income increase, while prices

 In response to the increase in income the

 A normal good is one that is bought in greater

 One important generalization about consumer

Annual Income (000)

 An inferior good is one that is bought in smaller

 A change in the price of one good causes both

 The part of the change in quantity demanded

 The part of the change in quantity demanded

 As shown in Figure 3.3, when the price of good

 The consumer was originally maximizing utility

Old budget constraint

Y** Old budget constraint

 If the individual had to stay on the U1 with the

 The movement from point B to X**, Y** results

 Using the hamburger-soft drink example from

 If the consumer bought his or her previous

 Even with constant real income the consumer

 An increase in PX will shift the budget line in as

New budget constraint

New budget constraint

 In Figure 3.4, both the substitution and income

 As shown in Figures 3.3 and 3.4, the

 This provides the rational for drawing

 If the substitution and income effects are small,

 The Bureau of Labor Statistics monthly

 The ratio of the current cost of the basket to

 Suppose the 1982 typical market basket

 To compute the cost of the same bundle of

 The CPI is defined as the ratio of the costs of

 The CPI does not take into account the real

 Suppose the 2002 relative prices change so

 Since I’’ is inside I’ (which is used to compute

 New products typically experience sharp

 The typical basket is bought at the same retail

 Measuring and correcting for these biases is

 Politicians have proposed caps on Cost of

 With an inferior good, the substitution effect

 The income effect results in increased

New budget constraint

New budget constraint

 The income effect reflects the reduced

 Since X** is less than X* the price increase in X

 If the income effect of a price change is strong

 When the price of potatoes rose in Ireland the

 The “lump-sum principle” hold that taxes that

 A tax on only good X raises its price resulting in

 The utility maximizing choice on I’’ is X2, Y2

 The intuitive explanation of the lump-sum

 The utility lass associated with the need to

 The lump-sum principle suggests that the

 In Figure 1 a subsidy on good X (constraint

 When the price of one good changes, it usually

 In addition, the substitution effect caused a

 Since, in this case, the income effect had a

Old budget constraint

B New budget constraint

 The movement from point B to X, Y results