Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Microeconomics
IV - Theory of Demand

Gergely Hajdu

1 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Demand Curve

Now that we have studied

(a) consumer preferences and
(b) consumer choice as a function of prices and income
We are ready to derive the demand curve

2 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Demand for good X

For given
• level of income

• prices of the other goods

we ask how much food the consumer would buy when its unit price is, for instance 5$
• That will be a point in the consumer’s demand

• other points can be found asking his/her food demand for different levels of food price

Note that the demand curve is a willingness to pay curve

3 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Price Consumption Curve and Demand for Good X

4 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Demand for good X

Suppose there are two goods, X and Y and we are interested in the demand for X
• At the initial price Px , Elizabeth faces the budget line AB

• Optimal consumption bundle is e at which Elizabeth consumes x units of the first good

• As Px diminishes, the budget line rotates out to AB1

• New optimal consumption bundle is e1 at which Elizabeth consumes x1

By repeating this exercise for different levels of Px , we obtain Elizabeth’s demand for good X

5 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Price Consumption Curve

It describes how changes in Px affects the consumer’s purchases of both goods

• It connects all the optimal consumption bundles as Px changes holding Py and I constant

• It is also called Price Expansion Path

6 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Effect of a Change in Income

What happens to Elizabeth’s choice of food when income changes?

• Keep prices constant

As we know, when his income increases, Elizabeth’s satisfaction rises

• The optimal consumption bundle will lie on a higher indifference curve

The Income Consumption Curve describes how changes in I affects the consumer’s purchases
• It connects all the optimal consumption bundles as I changes holding prices constant

7 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Engel Curve

The Engel curve relates the amount consumed of a good (e.g. food) to the level of income
• we ask how much food the consumer would buy when his/her income is, for instance, 100$

• That will be a point in the consumer’s Engel curve

• other points can be found asking his/her food demand for different income levels

8 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Income Consumption Curve and Engel Curve

9 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Normal Goods

A good is said to be normal if a consumer wants to buy more of it when his/her income rises
• For instance, Attila consumes more food as his income rises

• Food is then a normal good for Attila

When a good is normal, the income elasticity of demand is positive (and vice versa):

∆x I
x,I =
∆I x

Note that x,I > 0 only if the consumption of x increases as I rises

10 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Inferior Goods

A good is said to be inferior if a consumer wants to buy less of it when his/her income rises
• When a good is inferior, the income elasticity of demand is negative (and vice versa)

Often times a good becomes inferior when the consumer reaches a certain amount of income:
• junk food

• inexpensive clothing or cars

• potatoes in XIX Century Ireland

11 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Inferior Goods
Example of a good which is inferior for level of income above a certain threshold

12 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Finding the Demand Curve

No corner points

How can we derive algebraically the demand curve?

• Suppose that Attila’s utility is u(x, y) = xy

• M Ux = y, M Uy = x

• Let us find the demand for x (food) and y (clothing)

Again, we can use the two conditions

(a) Optimal consumption bundles lie on the budget line
(b) Tangency condition must hold
Note that unlike the previous lecture we do not take specific values of Px , Py , and I

13 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Finding the Demand Curve

No corner points

Px x + Py y = I (a)
M Ux Px
= (b)
M Uy Py
(b) is:
y Px Px
= ⇔y= x
x Py Py
substituting it into (a) yields:

Px I
Px x + Py x=I⇔x=
Py 2Px

14 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Finding the Demand Curve

No corner points

As a result:
Px I I
y= =
Py 2Px 2Py
Note that, for Attila, both food and clothing are normal goods:

 ∂x = 1
>0
∂I 2Px
 ∂y = 1
>0
∂I 2Py

15 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Finding the Demand Curve

When there are corner solutions

Suppose that Jennifer has preferences over movies (x) and pop-corns (y)
• Her utility function is u(x, y) = xy + 10x

• M Ux = y + 10, M Uy = x

Let us look for an interior solution: condition (b) is

y + 10 Px Px
= ⇔y= x − 10
x Py Py

substituting it into (a) yields:

Px I Py
Px x + P y x − 10Py = I ⇔ x = +5
Py 2Px Px

16 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Finding the Demand Curve

When there are corner solutions

As a result:
Px I Px Py I
y= +5 − 10 = −5
Py 2Px Py Px 2Py

• Negative quantities of pop-corn cannot be consumed

• Note that y is positive if and only if

I
> 5 ⇔ I > 10Py
2Py

17 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Finding the Demand Curve

When there are corner solutions

If I ≥ 10Py : 
I P
x =
2Px + 5 Pxy
I
y =
2Py −5

If I < 10Py : 
x = I
Px
y = 0

18 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Income and Substitution Effects

A decrease in the price of a good affects the consumer in two ways:

(a) As the price of a good falls, that good becomes less expensive relative to the other goods
(substitution effect)

• e.g. if the price of food decreases, Attila may buy more food and less clothes

(b) When the price of a good falls, purchasing power of the consumer goes up and he/she
could potentially buy the same initial bundle spending less (income effect)

• e.g. when the price of food decreases, Attila may afford to buy more clothes

Note that we observe only the total effect!

19 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution Effect

The substitution effect is the amount of the good the consumer would purchase after the price
change to achieve the same initial level of utility
• we isolate the effect that can be ascribed directly to the change in relative prices

To determine it, we must control for the change in real income

• We consider a budget line characterized by the new prices but a level of income such
that it is tangent to the initial indifference curve
• We call this budget line the decomposition budget line

20 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution Effect

In the figure on the next slide

• At the beginning, budget line is M1 N1

• the consumer chooses bundle E1 which lies on the indifference curve IC1

• he/she consumes x1 units of the good

The price of good x drops

• The substitution effect is the movement from E1 to E2

E2 is the decomposition bundle and is characterized by

(i) It lies on IC1 as the original consumption bundle E1
(ii) It is the point where the decomposition budget line M2 N2 is tangent to IC1

21 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Income and Substitution Effects

22 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Income Effect
The income effect is the change in the amount of the good consumed due to change in the
consumer’s purchasing power
• we isolate the effect that can be ascribed directly to the change in real income

In the previous figure the income effect is the movement from E2 to E3

• We restore the lost income and we consider the new (true) budget line M1 N3

• E3 is the point where the budget line M3 N3 is tangent to the highest indifference curve,
IC2
To summarize, the total change in the consumption of x due to a price drop is x3 − x1
• The substitution effect is x2 − x1

• The income effect is x3 − x2

23 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

In the case considered, when the price of food falls,

• the substitution effect leads to an increase in food consumption

• the income effect also contributes to increase food consumption

Both effects go in the same direction

• The demand for food is downward sloping (i.e. as food price goes down, demand
increases)

The income effect is not always positive, though

24 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Inferior Goods

• When the good is inferior, the

income effect is negative
• The negative income effect only
mitigates the positive substitution
effect

The demand curve will still be downward sloping

25 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Giffen Goods
What if the negative income effect outweighs the positive substitution effect?

The demand curve will still be upward sloping

• Giffen goods are theoretically interesting but they are not practically relevant (little
evidence of their existence)
26 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Let us find algebraically substitution and income effects

• Attila’s utility is u(x, y) = xy

• M Ux = y, M Uy = x

• Suppose I = 72, Px1 = 9 and Py = 1

• Then price of x falls to Px2 = 4

As you recall there are no corner points

• Three-step procedure

27 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Step 1

1. Find the initial (optimal) consumption bundle

We use the budget line and the tangency conditions:

Px1 x + Py y = I ⇔ 9x + y = 72 (a)

M Ux Px1 y
= ⇔ =9 (b)
M Uy Py x

• From (b), y = 9x
• substituting this into (a), 18x = 72 ⇔ x = 4
• y = 36
e1 = (4, 36)
28 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Step 2

2. Find the final consumption bundle

We use the budget line and the tangency conditions:

Px2 x + Py y = I ⇔ 4x + y = 72 (a’)

M Ux Px2 y
= ⇔ =4 (b’)
M Uy Py x

• From (b’), y = 4x
• substituting this into (a’), 8x = 72 ⇔ x = 9
• y = 36
e3 = (9, 36)
29 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Step 3

3. Find the decomposition consumption bundle

Consider that e2 lies on the same indifference curve as e1

• u(e1 ) = u(x = 4, y = 36) = 4 ∗ 36 = 144

xy = 144 (a”)

At e2 the initial indifference curve and the decomposition budget line are tangent
• slope of the indifference curve is − M Ux
M Uy

• decomposition budget line is parallel to final budget line, hence they have the same slope:
− PPx2
y

M Ux Px2 y
= ⇔ =4 (b”)
M Uy Py x
30 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Step 3 and results

• From (b”), y = 4x

• substituting this into (a”), 4x2 = 144 ⇔ x = 6

• y = 24

e2 = (6, 24)
• Total effect on x is 9 − 4 = 5

• Substitution effect is 6 − 4 = 2

• Income effect is 9 − 6 = 3

31 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Quasi-linear Utility Functions

Suppose Ester has a daily income of 10$ and purchases cheesecakes (x) and a composite good
(y)
√
• her utility function is u(x, y) = 2 x + y

• note that this utility function is quasi-linear

• Initial prices are Px1 = 0.5$ and Py = 1$

• Subsequently cheesecake price falls to Px2 = 0.2$

√
• Note that M Ux = 1/ x and M Uy = 1

Let us find substitution and income effects

32 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Quasi-linear Utility Functions

1. Find the initial (optimal) consumption bundle

Let us look for an interior solution

M Ux Px1 1 1
= ⇔√ =
M Uy Py x 2

Which yields x = 4
1
Px1 x + Py y = I ⇔ ∗ 4 + y = 10 ⇔ y = 8
2
e1 = (4, 8)

33 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Quasi-linear Utility Functions

2. Find the final consumption bundle

M Ux Px2 1 1
= ⇔√ =
M Uy Py x 5
Which yields x = 25

1
Px2 x + Py y = I ⇔ ∗ 25 + y = 10 ⇔ y = 5
5

e3 = (25, 5)

34 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Quasi-linear Utility Functions

3. Find the decomposition consumption bundle

e2 lies on the same indifference curve as e1 :
√
• u(e1 ) = u(x = 4, y = 8) = 2 ∗ 4 + 8 = 12
√
2 x + y = 12

At e2 the initial indifference curve and the decomposition budget line are tangent

M Ux Px2 1 1
= ⇔ √ = ⇔ x = 25
M Uy Py x 5

and
√
2∗ 25 + y = 12 ⇔ y = 2

e2 = (25, 2)
35 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Quasi-linear Utility Functions

Total effect of the price change on consumption of x is: 25 − 4 = 21

• Substitution effect is 25 − 4 = 21

• Income effect is null!

If income varies the consumption of x does not change

• income changes will only have repercussions on the consumption of good y

36 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Labor-Leisure Trade-off

Why does a consumer work?

• To have an income that he/she can spend on goods

• However, when the consumer works, he/she cannot enjoy leisure activities (e.g. doing
sport, sleeping, watching a movie) ⇒ trade-off
If the hourly wage increases, the consumer earns a higher income working the same initial
number of hours
• This leads to a substitution effect: working more to buy higher amounts of good

• If leisure is a normal good, its demand increases when the income rises

• Income effect works in the opposite direction of the substitution effect

37 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Substitution and Income Effects

Labor-Leisure Trade-off

Backward bending supply of labor 38 / 57

Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Consumer Surplus

Consumer surplus is the difference between the maximum amount a consumer is willing to pay
for a good and how much he/she ends up paying to purchase it in the marketplace
• Suppose you are willing to pay up to 1000 euros for the new i-phone

• But you buy it for just 800 euros

• You walk away with a consumer surplus of 200 euros

Why is it important?
• Suppose we do not know the consumer’s utility function

• but we know his/her demand function

Through the concept of consumer surplus, we can gauge the impact of price changes on
his/her well-being!

39 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Consumer Surplus
Example

Arnold likes working out but must pay an entrance fee any time he goes to the gym-center
number of work-out/week marginal willingness to pay
1 15$
2 14$
3 12.5$
4 10.5$
5 8$
6 5$
7 1.5$

40 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Consumer Surplus
Example

Suppose day-pass is 8$, Arnold will go to the gym 5 times per week, paying 40$
nu. of work-out/week m. w. to pay Arnold surplus
1 15$ 7$
2 14$ 6$
3 12.5$ 4.5$
4 10.5$ 2.5$
5 8$ 0$
tot. 60$ 20$

41 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Consumer Surplus
Typically, we represent the demand function as a smooth curve
• Q = 10 − 2p

• Suppose p = 3, what is the consumer surplus?

4 10 Q

1
The filled area is the consumer surplus: 2 ∗ (5 − P ) ∗ Q = 4
42 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Consumer Surplus

Suppose that the price decreases to 2

• What is its effect on the consumer surplus?

3
2

4 6 10 Q

The orange-filled area measures the increase in consumer surplus

43 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Compensating and Equivalent Variation

We are interested in the impact of a price change on the consumer’s well-being expressed in
monetary terms
(a) Compensating Variation (CV): How much do we have to increase/decrease the consumer’s
income if we want his/her welfare to remain the same after a change in prices?
(b) Equivalent Variation (EV): How much can we increase/decrease the consumer’s income to
induce the same welfare gain/loss as a change in prices?

44 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Compensating and Equivalent Variation

45 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Compensating and Equivalent Variation

Take up Ester’s example again:

√
• utility function is u(x, y) = 2 x + y

• Initial prices are Px1 = 0.5$ and Py = 1$ and her income is 10$

• Subsequently price of x falls to Px2 = 0.2$

√
• Note that M Ux = 1/ x and M Uy = 1

We found e1 = (4, 8), e2 = (25, 2) and e3 = (25, 5)

46 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Compensating Variation

The compensating variation is the difference between

(a) Ester’s income, 10$ and
(b) The income she would need to purchase the decomposition bundle e2 = (25, 2) at the
final prices Px2 = 0.2$ and Py = 1$
(b) is
0.2 ∗ 25 + 1 ∗ 2 = 7

and CV = 10 − 7 = 3

47 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Equivalent Variation

The equivalent variation is the difference between

(c) The income she would need to purchase a bundle as good as e3 = (25, 5) at the initial
prices, Px1 = 0.5$ and Py = 1$, and
(d) Ester’s income, 10$
To determine (c) we need to find such a bundle, that we call e4
• We know that e4 provides the same utility to Ester as e3
√
u(e3 ) = u(x = 25, y = 5) = 2 25 + 5 = 15

Hence, first condition is

√
2 x + y = 15

48 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Equivalent Variation

We also know that at e4 , the slope of the final indifference curve equals that of the initial
budget line:
M Ux Px1 1 1
= ⇔ √ = ⇔x=4
M Uy Py x 2
Thus,
√
2∗ 4 + y = 15 ⇔ y = 11

e4 = (4, 11). Then (c) is

0.5 ∗ 4 + 1 ∗ 11 = 13

and EV = 13 − 10 = 3
• CV = EV is due to the fact that there is no income effect

49 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Compensating and Equivalent Variation

Income Effect

Take up Attila’s example again:

• utility function is u(x, y) = xy

• Initial prices are Px1 = 9$ and Py = 1$ and his income is 72$

• Subsequently price of x falls to Px2 = 4$

• Note that M Ux = y and M Uy = x

We found e1 = (4, 36), e2 = (6, 24) and e3 = (9, 36)

50 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Compensating Variation
Income Effect

The compensating variation is the difference between

(a) Attila’s income, 72$ and
(b) The income he would need to purchase the decomposition bundle e2 = (6, 24) at the
final prices Px2 = 4$ and Py = 1$
(b) is 4 ∗ 6 + 1 ∗ 24 = 24 and CV = 72 − 48 = 24
Interpretation: Attila is indifferent between
• facing Px1 = 9$ and having 72$ and

• having 24$ less but facing a lower price Px2 = 4$

51 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Equivalent Variation
Income Effect

The equivalent variation is the difference between

(c) The income he would need to purchase a bundle as good as e3 = (9, 36) at the initial
prices, Px1 = 9$ and Py = 1$, and
(d) Attila’s income, 72$
To determine (c) we need to find e4
• We know that e4 provides the same utility to Attila as e3

u(e3 ) = u(x = 9, y = 36) = 9 ∗ 36 = 324

Hence, first condition is

xy = 324

52 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Equivalent Variation
Income Effect
We also know that at e4 , the slope of the final indifference curve equals that of the initial
budget line:
M Ux Px1 y
= ⇔ = 9 ⇔ y = 9x
M Uy Py x
Thus, 9x2 = 324 ⇔ x = 6 and y = 54. Therefore e4 = (6, 54) and (c) is

9 ∗ 6 + 1 ∗ 54 = 108

and EV = 108 − 72 = 36 > 24 = CV

Interpretation: Attila is indifferent between
• facing Px2 = 4$ and having 72$ and

• facing a higher price Px1 = 9$ but having 36$ more

53 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Market Demand

Consumer theory allows us to derive the demand curve of an individual consumer

• Policy makers and businesses often interested in market demand

We can derive market demand from individual demands

• It is just the horizontal sum of the demands of individual consumers

54 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Market Demand
Suppose that Attila and Julia are the only two consumers of redbull
• QA = 5 − P ⇔ P = 5 − QA
• QJ = 6 − 34 P ⇔ P = 8 − 43 QJ

QA QJ

5 6 Q

55 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Market Demand
When P ≥ 8 neither consumer buys redbull
When 8 > P ≥ 5, only Julia demands redbull
• For that price range, market demand equals Julia’s demand

When P < 5, both Attila and Julia want to buy redbull

• For that price range, market demand equals the sum of their demands:
3 7
QM = QA + QJ = (5 − P ) + (8 − P ) = 11 − P
4 4
To summarize 


0, when P ≥ 8

QM = 6 − 34 P, when 8 > P ≥ 5


11 − 7 P, when P < 5

4

56 / 57
Optimal Choice and Demand Income and Substitution Effects Consumer Surplus Market Demand

Market Demand

QA QJ QM

5 6 Q

57 / 57