Intermediate Microeconomics

Lecture 3

Choice and Demand

 Review: Indifference Curves
x2 z
p x
p y
x

x1
2
 Slopes of Indifference Curves
 The slope of an indifference curve (at
a given point) is its marginal rate-of-
substitution (MRS).

3
 Economic Rationality
A decision maker chooses its most
preferred alternative from those
available to it.

 The available choices constitute the

choice set.
 How is the most preferred bundle in
the choice set located?
 Optimal Choice
 Tofind the bundle in the budget set
that is on the highest indifference curve.

 Sincepreferences are well-behaved,

（ more is preferred to less）, we can
focus on the bundles that line on the
budget line.

5
Rational Constrained Choice
x2

More preferred
bundles

Affordable
bundles
x1
Rational Constrained Choice
x2

x2*

x1* x1
Rational Constrained Choice
x2 (x1*,x2*) is the most
preferred affordable
bundle.
How do we
mathematically
x2* solve for this
point?

x1* x1
 Rational Constrained Choice
 The most preferred affordable bundle
is the consumer’s ORDINARY
DEMAND at the given prices and
budget.

 Ordinary demands will be denoted by

x1*(p1,p2,m) and x2*(p1,p2,m).
 Rational Constrained Choice
 When x1* > 0 and x2* > 0 the
demanded bundle is INTERIOR.

 If
buying (x1*,x2*) costs $m then the
budget is exhausted since
p1x1* + p2x2* = m.
Rational Constrained Choice
x2 (x1*,x2*) is interior.

(x1*,x2*) exhausts the

budget.
x2*

x1* x1
Rational Constrained Choice
x2 The slope of the indiff.
curve at (x1*,x2*) equals
the slope of the budget
constraint.

x2*

x1* x1
 Rational Constrained Choice
 (x1*,x2*) satisfies two conditions:

 (a) the budget is exhausted;

p1x1* + p2x2* = m

 (b) the slope of the budget constraint

(-p1/p2) and
the slope of the indifference curve
containing (x1*,x2*) are equal at (x1*,x2*).
 Computing Ordinary Demands
 How can this information be used to
locate (x1*,x2*) for given p1, p2 and m?
 Computing Ordinary Demands
 Suppose
that the consumer has
Cobb-Douglas preferences.

U (x 1,x 2 )  x x
a
1
b
2
Computing Ordinary Demands -
a Cobb-Douglas Example.

U (x 1,x 2 )  x xa
1
b
2

 Then

U
MU1   ax 1a  1x b2
 x1

U
MU 2   bx 1a x b2  1
 x2
Computing Ordinary Demands -
a Cobb-Douglas Example.
 So the MRS is
a 1 b
 U /  x 1 ax x ax 2
MRS  -  1
 2
 U /  x 2 bx x
a b 1
1 2
bx 1

 At (x1*,x2*), MRS = -p1/p2 so

Computing Ordinary Demands -
a Cobb-Douglas Example.
 So the MRS is
a 1 b
 U /  x 1 ax x ax 2
MRS  -  1
 2
 U /  x 2 bx x
a b 1
1 2
bx 1

 At (x1*,x2*), MRS = -p1/p2 so

ax 2 p1 bp 1 *
  - x 
*
x1 (A)
bx 1 p2 2
ap 2
 Computing Ordinary Demands -
a Cobb-Douglas Example.
 (x1*,x2*) also exhausts the budget so

px  px  m
1 1
* *
2 2
(B)
Computing Ordinary Demands -
a Cobb-Douglas Example.
 So now we know that
bp 1 *
x  *
2 x1 (A)
ap 2
px  px  m
1 1
* *
2 2
(B)

am
x 
*
1
(a  b )p 1
 Computing Ordinary Demands
We find that the most preferred
affordable bundle for a consumer with
Cobb-Douglas preferences:

U (x 1,x 2 )  x x a
1
b
2

is am bm
(x , x )  (
* *
, ).
( a  b ) p1 ( a  b ) p 2
1 2
 Computing Ordinary Demands -
a Cobb-Douglas Example.
x2

bm
x2* 
( a  b ) p2

am
x1* 
( a  b ) p1
x1
 Rational Constrained Choice
 When x1* > 0 and x2* > 0
and (x1*,x2*) exhausts the budget,
and indifference curves have no ‘kinks’
the ordinary demands are obtained by
solving:
 (a) p1x1* + p2x2* = y
 (b) the slopes of the budget constraint, -
p1/p2, and of the indifference curve
containing (x1*,x2*) are equal at (x1*,x2*).
 Rational Constrained Choice
 But what if x1* = 0?
 Or if x2* = 0?

 Ifeither x1* = 0 or x2* = 0 then the

ordinary demand (x1*,x2*) is at a
corner solution to the problem.
 Special Cases
 Whatabout the preferences for
perfect substitutes?

25
Examples of Corner Solutions --
Perfect Substitutes
x2
MRS = -1

x1
Examples of Corner Solutions --
the Perfect Substitutes Case
x2
MRS = -1 Which is the
optimal bundle?

Slope = -p1/p2 with p1 > p2.

x1
Examples of Corner Solutions --
the Perfect Substitutes Case
x2
MRS = -1

Slope = -p1/p2 with p1 > p2.

x1
 Examples of Corner Solutions --
the Perfect Substitutes Case
x2
y MRS = -1
x 2* 
p2

Slope = -p1/p2 with p1 > p2.

x 1*  0 x1
 Examples of Corner Solutions --
the Perfect Substitutes Case
x2
MRS = -1

Slope = -p1/p2 with p1 < p2.

x 2*  0 y
x 1*  x1
p1
 Perfect Substitutes Case
So when U(x1,x2) = x1 + x2, the most
preferred affordable bundle is (x1*,x2*)
where
y 
( x , x )   ,0 
*
1
*
2 if p1 < p2
 p1 
and
 y 
( x , x )   0, 
*
1
*
2
if p1 > p2.
 p2 
Basically, you only buy the good that is cheaper
since they are perfectly substitutable. (What if p1
= p2 ?)
 Perfect Substitutes Case
x2
MRS = -1
y
p2 Slope = -p1/p2 with p1 = p2.

y
p1 x1
 Perfect Substitutes
x2 All the bundles in the
constraint are equally the
y
p2 most preferred affordable
when p1 = p2.

They are basically the

same products.
y
p1 x1
Examples of Corner Solutions --
Non-Convex Preferences
x2

x1
Examples of Corner Solutions --
Non-Convex Preferences
x2

x1
Examples of Corner Solutions --
Non-Convex Preferences
x2
Which is the most preferred
affordable bundle?

x1
Examples of Corner Solutions --
Non-Convex Preferences
x2
The most preferred
affordable bundle (on
the highest indiff.
curve)

x1
Examples of Corner Solutions --
Non-Convex Preferences
x2 Notice that the “tangency solution”
is not the most preferred affordable
bundle.
The most preferred
affordable bundle

x1
Examples of ‘Kinky’ Solutions --
the Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}

x2 = ax1

x1
Examples of ‘Kinky’ Solutions --
the Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}

x2 = ax1

x1
 Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}

Which is the most

preferred affordable bundle?

x2 = ax1

x1
 Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}
The most preferred
affordable bundle (on
the highest indiff. curve)
x2 = ax1

x1
 Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}

x2 = ax1
x2*

x1* x1
 Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}
(a) p1x1* + p2x2* = m

x2 = ax1
x2*

x1* x1
 Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}
(a) p1x1* + p2x2* = m
(b) x2* = ax1*

x2 = ax1
x2*

x1* x1
Examples of ‘Kinky’ Solutions --
the Perfect Complements Case
(a) p1x1* + p2x2* = m; (b) x2* = ax1*.
Substitution from (b) for x2* in (a) gives
p1x1* + p2ax1* = m
which gives
m am
x 
*
; x2 
*
.
p1  ap 2 p1  ap 2
1
 Examples of ‘Kinky’ Solutions --
the Perfect Complements Case
x2 U(x1,x2) = min{ax1,x2}

x2 = ax1
am
x 
*

p1  ap 2
2

x1* 
m x1
p1  ap 2
 With the analytical tools, what
kind of research questions can we
ask?

48
Properties of Demand Functions
 Comparativestatics analysis of
ordinary demand functions:

 How do ordinary demands

x1*(p1,p2,y) and x2*(p1,p2,y) change as
prices p1, p2 and income y change?

 Why do we care?
49
 Own-Price Changes
 How does x1*(p1,p2,y) change as p1
changes, holding p2 and y constant?
 Suppose only p1 increases, from p1’ to
p1’’ and then to p1’’’.

50
 Own-Price Changes
Fixed p2 and y.
x2
p1x1 + p2x2 = y
p1 = p1’
What happens if
p1 increases?

x1

51
 Own-Price Changes
Fixed p2 and y.
x2
p1x1 + p2x2 = y
p1 = p1’

X1 becomes
more
p1= p1’’ expensive
x1

52
 Own-Price Changes
Fixed p2 and y.
x2
p1x1 + p2x2 = y
p1 = p1’

p1=
p1’’’ p1= p1’’
x1

53
Own-Price Changes
Fixed p2 and y.
p1 = p1’

x1*(p1’)

54
 p1
Own-Price Changes
Fixed p2 and y.
p1 = p1’

p1’

x1*(p1’) x 1*

x1*(p1’)

55
 p1
Own-Price Changes
Fixed p2 and y.
p1 = p1’’

p1’

x1*(p1’) x 1*

x1*(p1’)

56
 p1
Own-Price Changes
Fixed p2 and y.
p1 = p1’’

p1’

x1*(p1’) x 1*

x1*(p1’)
x1*(p1’’)
57
 p1 Demand
Own-Price Changes for x1
Fixed p2 and y. decreases
as p1
increases.
p1’’

p1’

x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’)
x1*(p1’’)
58
 p1
Own-Price Changes
Fixed p2 and y.
p1 = p1’’’
p1’’

p1’

x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’)
x1*(p1’’)
59
 p1
Own-Price Changes
Fixed p2 and y.
p1 = p1’’’
p1’’

p1’

x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’’’) x1*(p1’)
x1*(p1’’)
60
 p1
Own-Price Changes
Fixed p2 and y. p1’’’

p1’’

p1’

x1*(p1’’’) x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’’’) x1*(p1’)
x1*(p1’’)
61
 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1

p1’’

p1’

x1*(p1’’’) x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’’’) x1*(p1’)
x1*(p1’’)
62
 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1

p1’’
p1 price
offer p1’
curve
x1*(p1’’’) x1*(p1’) x 1*
x1*(p1’’)

x1*(p1’’’) x1*(p1’)
x1*(p1’’)
63
 Own-Price Changes
 Thecurve containing all the utility-
maximizing bundles traced out as p1
changes, with p2 and y constant, is
the p1- price offer curve.

 The plot of the x1-coordinate of the

p1- price offer curve against p1 is the
ordinary demand curve for
commodity 1.
64
 Own-Price Changes
 What does a p1 price-offer curve look
like for Cobb-Douglas preferences?

65
 Own-Price Changes
 What does a p1 price-offer curve look
like for Cobb-Douglas preferences?
 Take
a b
U( x 1 , x 2 )  x 1 x 2 .
Then the ordinary demand functions
for commodities 1 and 2 are

66
 Own-Price Changes
a y
x*1 ( p1 , p 2 , y )  
a  b p1
and
b y
x*2 ( p1 , p 2 , y )   .
a  b p2
Notice that x2* does not vary with p1 so the
p1 price offer curve is flat

67
 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and y. for commodity 1
is
* ay
x1 
( a  b )p1

by
x 
*
2
(a  b )p 2 x 1*

x1*(p1’’’) x1*(p1’)
ay
x1*(p1’’) x 1* 
(a  b )p 1
68
 Own-Price Changes
 What does a p1 price-offer curve look
like for a perfect-complements utility
function?

69
 Own-Price Changes
 What does a p1 price-offer curve look
like for a perfect-complements utility
function?
U ( x 1 , x 2 )  m in  x 1 , x 2  .
Then the ordinary demand functions
for commodities 1 and 2 are

70
 Own-Price Changes
y
x*1 ( p 1 , p 2 , y )  x*2 ( p 1 , p 2 , y )  .
p1  p 2

With p2 and y fixed, higher p1 causes

smaller x1* and x2*.

71
 Own-Price Changes
y
x*1 ( p 1 , p 2 , y )  x*2 ( p 1 , p 2 , y )  .
p1  p 2

With p2 and y fixed, higher p1 causes

smaller x1* and x2*.

* * y
As p1  0 , x1  x 2  .
p2

72
 Own-Price Changes
y
x*1 ( p 1 , p 2 , y )  x*2 ( p 1 , p 2 , y )  .
p1  p 2

With p2 and y fixed, higher p1 causes

smaller x1* and x2*.
* * y
As p 1  0 , x 1  x 2  .
p2

* *
As p 1   , x1  x 2  0.

73
Own-Price Changes
Fixed p2 and y.
x2

x1
74
 p1
Own-Price Changes
Fixed p2 and y.
x2
p1 = p1’
y/p2
x*2  p1’
y
p1’ p2 y x 1*
x*1 
p1 ’ p 2

y
x*1  x1
p1’ p 2
75
 p1
Own-Price Changes
p1’ increases to p1’’
x2
p1 = p1’’
y/p2 p1’’

p1’
x*2 
y y x 1*
p1’’ p2 x*1 
p1’’  p 2

y
x*1  x1
p1’’  p 2
76
 Own-Price Changes p1
p1’’increases to p1’’’
p1’’’
x2
p1 = p1’’’
y/p2 p1’’

p1’

x*2  y x 1*
y x*1 
p1’’’  p 2
p1’’’  p2
y
x*1  x1
p1’’’  p 2
77
 p1
Ordinary
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1
x2 is
* y
p1’’ x1  .
y/p2 p1  p 2
x*2  p1’
y
p1  p2 y x 1*
p2

y
x*1  x1
p1  p 2
78
 Own-Price Changes
 What does a p1 price-offer curve look
like for a perfect-substitutes utility
function?
U(x1 , x 2 )  x1  x 2 .
Then the ordinary demand functions
for commodities 1 and 2 are

79
 Own-Price Changes
* 0 , if p 1  p 2
x 1 ( p1 , p 2 , y )  
 y / p 1 , if p 1  p 2
and
* 0 , if p 1  p 2
x 2 ( p1 , p 2 , y )  
 y / p 2 , if p 1  p 2 .

80
Own-Price Changes
Fixed p2 and y.
x2
p1 = p1’ < p2

Consume
only x1
x *2  0
* y
x1  x1
p1’
81
 p1
Own-Price Changes
Fixed p2 and y.
x2
p1 = p1’ < p2

p1’

* y x*
x1  1
p1’

x *2  0
* y
x1  x1
p1’
82
 p1
Own-Price Changes
Increase p1 to p1’’
x2
p1 = p1’’ = p2

p1’

x 1*

x1
83
 p1
Own-Price Changes
Fixed p2 and y.
x2
p1 = p1’’ = p2

p1’

x 1*

x1
84
 p1
Own-Price Changes
Fixed p2 and y.
x2
p1 = p1’’ = p2

* y p1’
x2 
p2 

 x 1*
 All the bundles on the
 constraint.

x 2  0    
*

* y x
*
x1  0 x1  1
p1’’
85
 p1
Own-Price Changes
p1 = p1’’ = p2
x2
p2 = p1’’

* y p1’
x2 
p2 
    
 x 1*
 0  x*1 
y
 p2

x 2  0    
*

* y x1
*
x1  0 x1 
p2
86
 p1
Own-Price Changes
p1 continues to increase to p1’’’ p1’’’
x2
p2 = p1’’

* y p1’
x2 
p2
x *1  0 x 1*

Only consume
X2 since X2 is
x *1  0 x1 cheaper.
87
 p1 Ordinary
Own-Price Changes demand curve
Fixed p2 and y. p1’’’ for commodity 1
x2 * y
x1 
p1
p2 = p1’’
p1 price
y p1’
offer
p2
curve     x 1*
y
0  x*1 
p2

x1
88
 Inverse Demand
 Usually
we ask “Given the price for
commodity 1 what is the quantity
demanded of commodity 1?”

 Butwe could also ask the inverse

question “At what price for
commodity 1 would a given quantity
of commodity 1 be demanded?”

89
 Inverse Demand
p1
Given p1’, what quantity is
demanded of commodity 1?

p1’

x1*

90
 Inverse Demand
p1
Given p1’, what quantity is
demanded of commodity 1?
Answer: x1’ units.

p1’

x1’ x1*

91
 Inverse Demand
p1
The inverse question is:
Given x1’ units are demanded,
what is the price of commodity 1?

x1’ x1*

92
 Inverse Demand
p1 The inverse question is:
Given x1’ units are demanded,
what is the price of commodity 1?

Answer: p1’
p1’

x1’ x1*

93
 Inverse Demand
 Takingquantity demanded as given
and then asking what must be price
describes the inverse demand
function of a commodity.

94
 Inverse Demand
A Cobb-Douglas example:
ay
x*1 
( a  b )p1

is the ordinary demand function

ay
p1 
( a  b ) x*1
is the inverse demand function.
95
 Inverse Demand
A perfect-complements example:
* y
x1 
p1  p 2

is the ordinary demand function

y
p1   p2
x*1

is the inverse demand function.

96
 How does the consumption
bundle change with an income
increase?

97
 Income Changes
 How does the value of x1*(p1,p2,y)
change as y changes, holding both
p1 and p2 constant?

98
Income Changes
Fixed p1 and p2.

y’ < y’’ < y’’’ You can

afford to buy
more.

99
Income Changes
Fixed p1 and p2.

y’ < y’’ < y’’’

x2’’’
x2’’
x2’

x1’ x1’’’
x1’’
100
Income Changes
Fixed p1 and p2.

y’ < y’’ < y’’’

Income
offer curve
x2’’’
x2’’
x2’

x1’ x1’’’
x1’’
101
 Income Changes
A plot of quantity demanded against
income is called an Engel curve.

102
Income Changes
Fixed p1 and p2.

y’ < y’’ < y’’’

Income
offer curve y
x2’’’ y’’’
x2’’ Engel
y’’
x2’ y’
curve;
good 1
x1’ x1’’’ x1’ x1’’’ x1*
x1’’ x1’’
103
Income Changes y Engel
Fixed p1 and p2.
curve;
y’’’ good 2
y’’
y’ < y’’ < y’’’
y’
Income
offer curve y x2’ x2’’’ x2*
x2’’
x2’’’ y’’’
x2’’ Engel
y’’
x2’ y’
curve;
good 1
x1’ x1’’’ x1’ x1’’’ x1*
x1’’ x1’’
104
How do we mathematically solve for
the Engel curve?

105
 Income Changes and Cobb-
Douglas Preferences
 An example of computing the
equations of Engel curves; the Cobb-
Douglas case.
a b
U( x 1 , x 2 )  x 1 x 2 .
 The ordinary demand equations are
* ay * by
x1  ; x2  .
( a  b )p1 ( a  b )p 2

106
 Income Changes and Cobb-
Douglas Preferences
* ay * by
x1  ; x2  .
( a  b )p1 ( a  b )p 2
Rearranged to isolate y, these are:
( a  b )p1 *
y x1 Engel curve for good 1
a
( a  b )p 2 *
y x 2 Engel curve for good 2
b

107
 Income Changes and Cobb-
Douglas Preferences
y ( a  b )p1 *
y x1
a Engel curve
for good 1

x1*
y
( a  b )p 2 *
y x2
b
Engel curve
for good 2
x2*
108
 Discussion
The Covid outbreak resulted in significant
decline in household spending.

Source: OECD Statistics Directorate

109
 Discussion

How to achieve a swift recovery of

consumption post-Covid?

Could you use the tools we have

learned to support your reasoning?

110
 Discussion: Stimulating Tools
Vouchers: XX yuan to spend on retail or
service outlets
Shopping Coupons: x-yuan off if purchasing
y-yuan or more.

Q:What design features could affect

the stimulating effects? 111
 Income Changes and Perfectly-
Complementary Preferences
 The perfectly-complementary case.
U ( x 1 , x 2 )  m in  x 1 , x 2  .

 Couldyou derive the Engel curves

for good 1 and 2?

112
 Income Changes and Perfectly-
Complementary Preferences
 The perfectly-complementary case.
U ( x 1 , x 2 )  m in  x 1 , x 2  .

 The ordinary demand equations are

* * y
x1  x 2  .
p1  p 2

113
Income Changes and Perfectly-
Complementary Preferences
* * y
x1  x 2  .
p1  p 2
Rearranged to isolate y, these are:
*
y  ( p1  p 2 ) x 1 Engel curve for good 1
*
y  ( p1  p 2 ) x 2 Engel curve for good 2

114
Income Changes
Fixed p1 and p2.
x2
y’ < y’’ < y’’’

x2’’’
x2’’
x2’

x1’ x1’’’ x1
x1’’
115
Income Changes y Engel
Fixed p1 and p2.
curve;
y’’’ good 2
x2 y’’
y’ < y’’ < y’’’
y’

y x2’ x2’’’ x2*

x2’’
x2’’’ y’’’
x2’’ Engel
y’’
x2’ curve;
y’
good 1
x1’ x1’’’ x1 x1’ x1’’’ x1*
x1’’ x1’’
116
Income Changes y Engel
Fixed p1 and p2.
curve;
y’’’ good 2
y’’
y’
y  ( p 1  p 2 )x *
2
y x2’ x2’’’ x2*
x2’’
y’’’
Engel
y’’
y  ( p 1  p 2 )x 1
*
y’
curve;
good 1
x1’ x1’’’ x1*
x1’’
117
 Income Changes and Perfectly-
Substitutable Preferences
 The perfectly-substitution case.
U(x1 , x 2 )  x1  x 2 .

 The ordinary demand equations are?

118
Income Changes and Perfectly-
Substitutable Preferences
* 0 , if p1  p 2
x 1 ( p1 , p 2 , y )  
 y / p 1 , if p1  p 2

* 0 , if p 1  p 2
x 2 ( p1 , p 2 , y )  
 y / p 2 , if p 1  p 2 .

119
 Income Changes and Perfectly-
Substitutable Preferences
* 0 , if p 1  p 2
x 1 ( p1 , p 2 , y )  
 y / p 1 , if p 1  p 2

* 0 , if p 1  p 2
x 2 ( p1 , p 2 , y )  
 y / p 2 , if p 1  p 2 .
y *
and x 2  0
*
Suppose p1 < p2. Then x1 
p1

120
 Income Changes and Perfectly-
Substitutable Preferences
* 0 , if p 1  p 2
x 1 ( p1 , p 2 , y )  
 y / p 1 , if p 1  p 2

* 0 , if p 1  p 2
x 2 ( p1 , p 2 , y )  
 y / p 2 , if p 1  p 2 .
y *
and x 2  0
*
Suppose p1 < p2. Then x1 
p1
*
y  p 1x 1 and x 2  0 .
*
121
 Income Changes and Perfectly-
Substitutable Preferences
y y
*
* x 2  0.
y  p 1x 1

x1* 0 x2*
Engel curve Engel curve
for good 1 for good 2
122
 Income Changes
 In
every example so far the Engel
curves have all been straight lines.

 Q: Is this true in general?

123
 Income Changes

 A:No. Engel curves are straight

lines if the consumer’s preferences
are homothetic.

124
 Homotheticity
A consumer’s preferences are
homothetic if and only if
(x1,x2) p (y1,y2)  (kx1,kx2) p (ky1,ky2)
for every k > 0.
 Consumer’s preferences only depend
on the ratio of good 1 to good 2.
 That is, the consumer’s MRS is the
same anywhere on a straight line
drawn from the origin.
125
 A Nonhomothetic Example
 Quasilinear preferences are not
homothetic.
U(x1 , x 2 )  f(x1 )  x 2 .
 For example,
U(x1 , x 2 )  x1  x 2 .

126
 Quasi-linear Indifference Curves
x2 Each curve is a vertically shifted
copy of the others.

x1
127
Income Changes; Quasilinear
Utility X1 increases
x2 first and then
stops
increasing.

y Engel
curve
for
good 1
x1 ~
x1 x1*
~
x1
128
 Income Changes; Quasilinear
Utility
 Increasing the income doesn’t
change the demand for good 1 at all,
and all the extra income goes to the
consumption of good 2.

 Itis this realistic? Can you give a

real-life example?

129
 Income Changes; Quasilinear
Utility
 Suppose good 1 is rice and good 2
represents all other goods.

 InitiallyI may spend my income only on

rice to survive.

 But when my income gets large enough, I

stop buying additional rice and all my
extra income is spent on other goods.

130
 Income Changes; Quasilinear
Utility
 Thisassumption may be plausible when
we examine a choice between all other
goods and some single good that isn’t a
large part of the budget.

131
 Does the demand for a good always
increase as the income increases?

132
 Normal and Inferior
 Normal good： the demand for a normal
good would increase when income
increases.

 Inferior good: an increase in income

results in a reduction in its consumption
(low-quality good）.

133
 Does the demand for a good always
increase as its own price reduces?

134
 Ordinary Goods
A good is called ordinary if the
quantity demanded of it always
increases as its own price decreases.

135
 Ordinary Goods
Fixed p2 and y.
x2 p1 decreases, the
budget line
becomes flatter
and the quantity
demanded of
good 1 increases.

x1
136
 Ordinary Goods
Fixed p2 and y.
x2
p1 price
offer
curve

x1
137
 Ordinary Goods
Fixed p2 and y. Downward-sloping
x2 p1 demand curve


p1 price
offer Good 1 is
curve ordinary

x 1*
Quantity demanded
increases as price
x1 decreases.
138
 Giffen Goods
 If,for some values of its own price,
the quantity demanded of a good
rises as its own-price increases then
the good is called Giffen.
 Do you have any examples?

139
 Giffen Goods
Fixed p2 and y.
x2
A decrease in p1
reduces the
consumption of x1.

x1
140
 Giffen Goods
 Withthe extra money you have saved
because of the lower price of the
good, you decide to consume even
more better-quality stuff and reduce
your consumption of the Giffen good.

 The price change is to some extent

like an income change.

141
 Giffen Goods
A Giffen good is a low-income, non-
luxury good for which demand
increases as the price increases.

 The income effect of the price

change more than offsets the
substitution effect (will discuss more
later).

142
 Does the demand of a good
increase/decrease as the price of the
other good goes up?

143
 Cross-Price Effects
 Ifan increase in p2
– increases demand for commodity 1
then commodity 1 is a substitute for
commodity 2.

– reduces demand for commodity 1

then commodity 1 is a complement
for commodity 2.

144
 Cross-Price Effects
Perfect-complements example:
y
x*1 
p1  p 2
so
 x*1 y
  0.
 p2  p1  p 2  2

Therefore commodity 2 is a
complement for commodity 1.
145
 Cross-Price Effects
A Cobb- Douglas example:
by
x*2 
( a  b )p 2
so
 x*2
 0.
 p1
Therefore commodity 1 is neither a
complement nor a substitute for
commodity 2.
146
 Exercise
Linda’s preferences over magazines (M)
and books (B) are given by:

147
 Exercise
Linda’s preferences over magazines (M)
and books (B) are given by:

148
 Effects of a Price Change
 What happens when a commodity’s
price decreases?

1. Substitution effect: the

commodity is relatively cheaper, so
consumers substitute it for now
relatively more expensive other
commodities.

149
 Effects of a Price Change
2. Income effect: the consumer’s
budget of $y can purchase more
than before, as if the consumer’s
income rose, with consequent
income effects on quantities
demanded.

150
 Effects of a Price Change
Consumer’s budget is $y.
x2
y Original choice
p2

x1

151
 Effects of a Price Change
Consumer’s budget is $y.
x2
Lower price for commodity 1
y pivots the constraint outwards.
p2

x1

152
 Effects of a Price Change
x2
Now only $y’ are needed to buy the
y original bundle at the new prices,
p2 as if the consumer’s income has
increased by $y - $y’.
y'
p2

x1

153
 Effects of a Price Change
 Changes to quantities demanded due
to this ‘extra’ income are the income
effect of the price change.

154
 Effects of a Price Change
 Slutskydiscovered that changes to
demand from a price change are
always the sum of a pure
substitution effect and an income
effect.

155
 Real Income Changes
 Slutsky asserted that if, at the new
prices,
– less income is needed to buy the
original bundle, “real income” is
increased
– more income is needed to buy the
original bundle, “real income” is
decreased

156
 Real Income Changes
x2

Original budget constraint and choice

x1

157
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint

x1

158
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint; real
income has risen

x1

159
 Real Income Changes
x2

Original budget constraint and choice

x1

160
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint

x1

161
 Real Income Changes
x2

Original budget constraint and choice

New budget constraint; real
income has fallen

x1

162
 Pure Substitution Effect
 Toisolate the change in demand due
only to the change in relative prices:

 “What is the change in demand when

the consumer’s income is adjusted
so that, at the new prices, she can
only just buy the original bundle?”

163
 Pure Substitution Effect Only
x2

x 2’

x 1’ x1

164
 Pure Substitution Effect Only
x2

x 2’

x 1’ x1

165
 Pure Substitution Effect Only
x2

x 2’

x 1’ x1

166
 Pure Substitution Effect Only
x2

x 2’

x2’’

x 1’ x1’’ x1

167
 Pure Substitution Effect Only
x2

x 2’

x2’’

x 1’ x1’’ x1

168
 Pure Substitution Effect Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
x 2’

x2’’

x 1’ x1’’ x1

169
 Pure Substitution Effect Only
x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’)  (x1’’,x2’’) is the
x 2’
pure substitution effect.
x2’’

x 1’ x1’’ x1

170
 And Now The Income Effect
x2

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1

171
 And Now The Income Effect
x2 The income effect is
(x1’’,x2’’)  (x1’’’,x2’’’).

x 2’ (x1’’’,x2’’’)

x2’’

x 1’ x1’’ x1

172
The Overall Change in Demand
x2 The change to demand due to
lower p1 is the sum of the
income and substitution effects,
(x1’,x2’)  (x1’’’,x2’’’).
x 2’
(x1’’’,x2’’’)
x2’’

x 1’ x1’’ x1

173
Substitution and Income Effects
• The pivot gives the substitution effect,
and the shift gives the income effect.

• Step 1: (pivot) a movement where the

slope of the budget line changes while
the purchasing power stays the same

174
Substitution and Income Effects
• Step 2: (shift) a movement where the
slope stays constant, and the purchasing
power changes.

• The decomposition is hypothetical. In

reality, the consumer simply observes a
change in price and chooses a new
bundle of goods in response (one step).

175
Slutsky’s Effects for Normal Goods
 Do these two effects work in the
same direction?

176
Slutsky’s Effects for Normal Goods
 Most goods are normal (i.e. demand
increases with income).
 The substitution and income effects
reinforce each other when a normal
good’s own price changes.
 The two effects work in the same
direction.

177
Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because
higher income increases
demand, so the income
and substitution
x 2’ (x1’’’,x2’’’) effects reinforce
each other.
x2’’

x 1’ x1’’ x1

178
 Slutsky’s Effects for Normal Goods
 Since both the substitution and income
effects increase demand when own-
price falls, a normal good’s ordinary
demand curve slopes down.

 TheLaw of Downward-Sloping Demand

therefore always applies to normal
goods.

179
Slutsky’s Effects for Income-Inferior
Goods
 Some goods are income-inferior (i.e.
demand is reduced by higher
income).

 The substitution and income effects

oppose each other when an income-
inferior good’s own price changes.

180
Slutsky’s Effects for Income-Inferior
Goods
x2

x 2’

x 1’ x1

181
Slutsky’s Effects for Income-Inferior
Goods
x2

x 2’

x 1’ x1

182
Slutsky’s Effects for Income-Inferior
Goods
x2

x 2’

x 1’ x1

183
Slutsky’s Effects for Income-Inferior
Goods
x2

x 2’

x2’’

x 1’ x1’’ x1

184
Slutsky’s Effects for Income-Inferior
Goods
x2
The pure substitution effect is as for
a normal good. But, ….

x 2’

x2’’

x 1’ x1’’ x1

185
Slutsky’s Effects for Income-Inferior
Goods
x2 The pure substitution effect is as for a
normal good. But, the income effect is
in the opposite direction.
(x1’’’,x2’’’)
x 2’

x2’’

x 1’ x1’’ x1

186
Slutsky’s Effects for Income-Inferior
Goods
x2
The overall changes to demand are
the sums of the substitution and
(x ’’’,x ’’’) income effects.
1 2
x 2’

x2’’

x 1’ x1’’ x1

187
 Slutsky’s Effects for Income-
Inferior Goods
A Giffen good is an inferior good and
the contrary income effect more than
offsets the substitution effect, and the
net effect of its price increase is to
increase demand for it.

188