Demand function

Schotter, Chapter 3 or 4
Summary
• Assumption for this chapter: Impersonal markets
• The problem of consumer choice
• Income expansion paths: inferior and superior goods; homothetic
preferences
• Price consumption paths
• Demand curves, utility functions
• Slope of the Demand Curve: Income and Substitution Effects (normal and
giffen goods)
• Compensated and Uncompensated demand
• Deriving the demand curve analytically
Assumption for this chapter: Impersonal mkts
• Assumption: competitive markets
• Markets are institutions, and so far… we lived in world without them
Assumption for this chapter: Impersonal mkts
• Assumption: competitive markets
• Markets are institutions, and so far… we lived in world without them
• Characteristics of competitive markets:
• Fixed prices. NO BARGAINING (impersonal markets…)
• Given income to spend
Assumption for this chapter: Impersonal mkts
• Assumption: competitive markets
• Markets are institutions, and so far… we lived in world without them
• Characteristics of competitive markets:
• Fixed prices. NO BARGAINING (impersonal markets…)
• Given income to spend
• Consumer problem:
- given my income and my tastes
- for each price of a good (p)
- how much quantity I demand (q)
Assumption for this chapter: Impersonal mkts
• Assumption: competitive markets
• Markets are institutions, and so far… we lived in world without them
• Characteristics of competitive markets:
• Fixed prices. NO BARGAINING (impersonal markets…)
• Given income to spend
• Consumer problem:
- given my income and my tastes
- for each price of a good (p) DEMAND

- how much quantity I demand (q)

The Problem of Consumer Choice
The Problem of Consumer Choice
• Consumers have:
• Tastes Indifference curves (and/or utility function)
• Income Budget constraints (feasible consumption sets)
• Competitive markets have:
• Prices
• Consumer problem: given tastes, income, and prices, how much
quantity of a good to demand.
The Problem of Consumer Choice
• Consumer problem: given tastes, income, and prices, how much q?
• Concept:
• Relative prices: ratio that tells how much a consumer in a market would have
to forgo of one good in order to receive units of another
• Examples:
- if the ratio of 𝑥1 and of 𝑥2 is 1:1, means that…
Price ratio 1:1 𝑥2

𝑥1
The Problem of Consumer Choice
• Consumer problem: given tastes, income, and prices, how much q?
• Concept:
• Relative prices: ratio that tells how much a consumer in a market would have
to forgo of one good in order to receive units of another
• Examples:
- if the ratio of 𝑥1 and of 𝑥2 is 1:1, means that…
- If the ratio of 𝑥1 and of 𝑥2 is 2:1, means that…
 𝑥2
Price ratio 1:1

Price ratio 2:1

𝑥1
The Problem of Consumer Choice
• Consumer problem: given tastes, income, and prices, how much q?
• Concept:
• Relative prices: ratio that tells how much a consumer in a market would have
to forgo of one good in order to receive units of another
• Examples:
- if the ratio of 𝑥1 and of 𝑥2 is 1:1, means that…
- If the ratio of 𝑥1 and of 𝑥2 is 2:1, means that…
- If the ratio of 𝑥1 and of 𝑥2 is 3:1, means that…
 𝑥2
Price ratio 1:1

Price ratio 2:1

Price ratio 3:1

𝑥1
 The Problem of Consumer Choice
• Consumer problem: given tastes, income, and prices, how much q?
Let 𝐼1, 𝐼2 , 𝐼3 represent the indifferences
curve of our agent.

Let 𝑝1 = 𝑝2 = 1

Let W = 20

Then, the budget constraint will be:

𝑊 = 𝑝1 . 𝑥1 + 𝑝2∙ 𝑥2
20 = 𝑥1 + 𝑥2
Income expansion paths
Inferior goods
Superior goods
Homothetic preferences
Income expansion paths
• Suppose that in our economy prices of our two goods remain constant BUT we
there is a change in the income of our agent. Suppose that we increase her
income.

What will happen to the demanded amount of goods 1 and 2?

Let 𝑝1 = 𝑝2 = 1

Initially W1 = 20
Then, the budget constraint
20 = 𝑥1 + 𝑥2

We then increase income so that W2 = 40,

while prices remain the same. New budget
constraint:
40 = 𝑥1 + 𝑥2

We then increase income so that W3 = 60,

while prices remain the same. New budget
constraint:
60 = 𝑥1 + 𝑥2
 Income expansion path:
path connecting optimal consumption
bundles that shows how a consumer
changes his quantity demanded of specified
goods as his income changes and
prices remain constant
5 mins to solve this problem
Solution
 Solution

12,000 = 4,000 𝑥𝑟𝑜𝑐𝑘 + 1,000𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟

Solution
 Solution

12,000 = 6,000 𝑥𝑟𝑜𝑐𝑘 + 1,000𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟

Solution
 𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟𝑠

12,000 = 4,000𝑥𝑟𝑜𝑐𝑘 + 1,000𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟

12,000 = 6,000𝑥𝑟𝑜𝑐𝑘 + 1,000𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟 𝑥𝑟𝑜𝑐𝑘

Solution
 Solution

Before the increase, the price ratio is 4:1

After the increase, the price ratio is 6:1
Solution
 𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟𝑠

12,000 = 4,000𝑥𝑟𝑜𝑐𝑘 + 1,000𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟

8,000 = 4,000𝑥𝑟𝑜𝑐𝑘 + 1,000𝑥𝑠𝑝𝑒𝑎𝑘𝑒𝑟 𝑥𝑟𝑜𝑐𝑘

Income expansion paths: inferior and superior
goods
• Superior good: a good for which demand increases as the income of the
consumer increases and the relative prices remain constant

Examples??
Income expansion paths: inferior and superior
goods
• Superior good: a good for which demand increases as the income of the
consumer increases and the relative prices remain constant
Income expansion paths: inferior and superior
goods
• Superior good: a good for which demand increases as the income of the
consumer increases and the relative prices remain constant
• Inferior good: a good for which demand decreases as the income of the
consumer increases and the relative prices remain constant

Examples?
Income expansion paths: inferior and superior
goods
• Superior good: a good for which demand increases as the income of the
consumer increases and the relative prices remain constant
• Inferior good: a good for which demand decreases as the income of the
consumer increases and the relative prices remain constant
Superior good
Inferior good
What does it make a good inferior or superior?
What does it make a good inferior or superior?

Preferences!!
That is, the shape of the indifference curve
Income expansion paths:
homothetic preferences
• What preferences would increase consumption of both goods proportionally
as income increase?
Income expansion paths:
homothetic preferences
• What preferences would increase consumption of both goods proportionally
as income increase?
• Homothetic preferences: preferences that will increase the purchase of goods
proportionally as income increases and price remain constant.
• Constant MRS
• Feature: all goods are superior with homothetic preferences
Price Consumption paths
Price-Consumption paths
• So far, we have analyzed what happens if prices are constant and income changes
Price-Consumption paths
• So far, we have analyzed what happens if prices are constant and income changes

• Now, we are going to suppose that income remains constant BUT the price of
ONE of our goods changes. That is, relative prices changes.

What will happen to the demanded amount of goods 1 and 2?

Price-Consumption paths
• So far, we have analyzed what happens if prices are constant and income changes

• Now, we are going to suppose that income remains constant BUT the price of
ONE of our goods changes. That is, relative prices changes.

What will happen to the demanded amount of goods 1 and 2?

Price-Consumption paths
• Price-consumption path: curve representing how consumption will vary when one
price changes but all other prices and the consumer’s income remain constant.
DEMAND CURVE
and utility functions
Demand Curve
Utility functions: nonconvex preferences
DEMAND CURVE
• Demand curve: curve
that represents
graphically the
relationship between
the quantity of a good
demanded by a
consumer and the
price of that good as
the price varies
DEMAND CURVES
• We build demand curve from our previous analysis
DEMAND CURVES
• NOTE THAT: every point on the demand curve, must be a tangency point of the
agent. That means that Marginal Utility Agent = MRS in the budget constraint
5 mins to solve this problem
 SOLUTION

Conditions to be a point on the demand curve:

- MU = MRS
- Belong to the budget line
 SOLUTION

Condition 1: 𝑀𝑈𝑠𝑢𝑠ℎ𝑖
= 𝑀𝑅𝑆𝑠𝑢𝑠ℎ𝑖 𝑓𝑜𝑟 𝑒𝑔𝑔𝑠
𝑀𝑈𝑒𝑔𝑔

𝑒 𝑝𝑠
In this case, condition 1 is satisfied if: =
𝑠 𝑝𝑒
 SOLUTION

Condition 1: 𝑀𝑈𝑠𝑢𝑠ℎ𝑖
= 𝑀𝑅𝑆𝑠𝑢𝑠ℎ𝑖 𝑓𝑜𝑟 𝑒𝑔𝑔𝑠
𝑀𝑈𝑒𝑔𝑔
25 3
Case a): 10 ≠ 2
𝑒 𝑝𝑠 15
Case b): 10 = 2
3
In this case, condition 1 is satisfied if: =
𝑠 𝑝𝑒
20 20 60 3
Case c): 13+ 1/3 = 40/3 = 40 = 2
 SOLUTION

Condition 2: 𝑝𝑠 𝑠 + 𝑝𝑒 𝑒 = 𝐼𝑛𝑐𝑜𝑚𝑒

Case b): 3 ∗ 15 + 2 ∗ 10 ≠ 80

In this case, condition 2 is satisfied if: 3𝑠 + 2𝑒 = 80 𝟏

Case c): 𝟑 ∗ 𝟏𝟑 + 𝟑 + 𝟐 ∗ 𝟐𝟎 = 𝟖𝟎
Nonconvex preferences and Demand
• Why did we assume convex preferences? (Remember, convex preferences meant
that the utility obtained by a mix of two goods with the same utility was at least
as good as the utility provided by the goods)
Slope of the Demand Curve:
Income and Substitution Effects
Slope of a well-behaved demand
Income effect
Substitution effect
Slope of a well-behaved demand
• Well-behaved: preferences are strictly convex, nonsatiable, and selfish
Initially: prices are p’ and we are in point e.

Next, prices of good 1 decrease to p’’. We move to f.

We derive the demand: downward sloping

But… why does an agent consume more of
good 1 when there is a price decrease?
But… why does an agent consume more of
good 1 when there is a price decrease?

Income effect
Substitution effect
Income Effect
• A decrease in price may lead to consume more because it is as if the
agent became wealthier (real income increases).
• If the good is superior (remember what was it!): then he will want
more.
• If the good is inferior (remember what was it!): then he will want less.
Income Effect
• A decrease in price may lead to consume more because it is as if the
agent became wealthier (real income increases).
• If the good is superior (remember what was it!): then he will want
more.
• If the good is inferior (remember what was it!): then he will want less.

• Income effect: the impact of an income induced change in demand

caused by a change in price
Substitution Effect
• A decrease in price may lead to consume more because now the good
is cheaper (relative prices have changed and that leads the agent to
change his consumption basket)
• If good 1 becomes cheaper, you may want to get more of good 1 and
less of good 2.
Substitution Effect
• A decrease in price may lead to consume more because now the good
is cheaper (relative prices have changed and that leads the agent to
change his consumption basket)
• If good 1 becomes cheaper, you may want to get more of good 1 and
less of good 2.

• Substitution effect: the change in demand that results from an

attempt to substitute a good whose prices has decreased for another
good whose price has remained constant after having nullified the
implicit income effect.
Income and Substitution effects combined
Income and Substitution effects combined
• Previous example: both income and substitution effect led to higher
consumption in good 1.
• Income effect: superior good
• Substitution effect
Income and Substitution effects combined
• Previous example: both income and substitution effect led to higher
consumption in good 1.
• Income effect: superior good
• Substitution effect
• Yet, they may go in opposite directions
• Income effect: inferior good
• Substitution effect
Income and Substitution effects combined
• Normal goods: A good whose demand curve is downward sloping
• Substitution effect: always lead to higher consumption of a good that becomes
relatively cheaper
• Income effect: might lead to higher or lower consumption (inferior or superior
goods) but if the income effect is negative (inferior good) it does not offset the
substitution effect
Income and Substitution effects combined
• Normal goods: goods whose demand curve is downward sloping
• Substitution effect: always lead to higher consumption of a good that becomes
relatively cheaper
• Income effect: might lead to higher or lower consumption (inferior or superior
goods) but if the income effect is negative (inferior good) it does not offset the
substitution effect
• Giffen goods: goods whose demand is upward sloping (unusual)
REASON:
- INFERIOR GOOD: the income
effect offsets the substitution
effect
- “Deep” reason: preferences
(indifference curves)
Income and Substitution effects combined
• Normal goods: goods whose demand curve is downward sloping
• Substitution effect: always lead to higher consumption of a good that becomes
relatively cheaper
• Income effect: might lead to higher or lower consumption (inferior or superior
goods) but if the income effect is negative (inferior good) it does not offset the
substitution effect
• Giffen goods: goods whose demand is upward sloping (unusual)
• Substitution effect: always lead to higher consumption of a good that becomes
relatively cheaper
• Income effect: lower consumption (inferior good) and offsets the substitution
effect (larger income effect than substitution effect)
Compensated and
uncompensated demand curves
Compensated and Uncompensated Demand
Curves
• Uncompensated demand function: a demand function that represents
the relationship between the price of a good the quantity demanded,
which includes both the substitution and income effects of prices
changes.
Compensated and Uncompensated Demand
Curves
• Uncompensated demand function: a demand function that represents
the relationship between the price of a good the quantity demanded,
which includes both the substitution and income effects of prices
changes.
• Compensated demand function: a hypothetical demand curve in which
the income effect has been removed. Thus, you see the changes in
consumption due only to the substitution effect and utility remains
constant.
We start in e.
Next, there is a price decrease in good 1. We move to a. Removing the income effect we go to point d. We
plot a and d in the demand curve
Next, price of good 1 decreases even more and we move to point c. Removing the income effect we go back
to f. We plot both c and f
Deriving the demand curve
analytically
Deriving the demand curve analytically
• So far, we have seen that the demand curve can be derived graphically
from:
• Indifference curve (which represents utility)
• Budget constraint
DEMAND CURVES
Remember…
Deriving the demand curve analytically
• So far, we have seen that the demand curve can be derived graphically
from:
• Indifference curve (which represents utility)
• Budget constraint
• Now, we are going to derive the demand function (represented by the
curve). We need:
• Utility function: 𝑢(𝑥1 , 𝑥2 )
• Budget constraint: 𝑊 = 𝑝1 𝑥1 + 𝑝2 𝑥2
Deriving the demand curve analytically
Deriving the demand curve analytically
Deriving the demand curve analytically

𝜕𝐿(𝑥1 , 𝑥2 , 𝜆)
=0
𝜕𝑥1
𝜕𝐿(𝑥1 , 𝑥2 , 𝜆)
=0
𝜕𝑥2
𝜕𝐿 𝑥1 , 𝑥2 , 𝜆
=0
𝜕𝜆
Deriving the demand curve analytically
𝜕𝐿(𝑥1 , 𝑥2 , 𝜆)
=0
𝜕𝑥1
𝜕𝐿(𝑥1 , 𝑥2 , 𝜆)
=0
𝜕𝑥2
𝜕𝐿 𝑥1 , 𝑥2 , 𝜆
=0
𝜕𝜆

𝑥1∗ = 𝑓1 𝑊, 𝑝1 , 𝑝2
This is just
MATHEMATICAL
NOTATION
𝑥2∗ = 𝑓2 𝑊, 𝑝1 , 𝑝2
𝜆∗ = 𝑓3 (𝑊, 𝑝1 , 𝑝2 )
Example
Example
Example
Example
Example
Example
Example
Example