Chapter 5 – The Theory of Demand

• Thus far we have studied supply and

demand and their equilibrium
• In this chapter we will see how consumer
theory creates the demand curve
• Shifts in demand will be dissected and
consumer choices will be investigated
further

1
 Chapter 5 – The Theory of Demand

• In this chapter we will study:

5.1 Price Consumption Curve
5.2 Deriving the Demand Curve
5.3 Income Consumption Curve
5.4 Engel Curve
5.5 Substitution and Income Effects
5.6 Consumer Surplus
2
Chapter 5 – The Theory of Demand

5.7 Compensating & Equivalent Variation

5.8 Market Demand
5.9 Labor and Leisure
5.10 Consumer Price Index (CPI)

3
 Y (units)
Demand and Optimal Choice

At a given income and faced with prices

Px and Py,an individual will maximize
their utility given the Tangency condition,
resulting in a consumption of
10 Good x as seen below:
•

PX = 4
0 XA=2 XB=10 X (units)
4
 Y (units)
Demand and Optimal Choice

When the price of x decreases, a

consumer will maximize given the new
budget line and a new amount of x will
10
be consumed.

•
•
PX = 4 PX = 2
0 XA=2 XB=10 20 X (units)
5
 Y (units) 5.1 The Price Consumption Curve

The price consumption curve for good x

plots all the utility maximization points as
the price of x changes. This reveals an
individual’s demand curve for good x.

10
Price consumption curve
•
• •
PX = 1

PX = 4 PX = 2
0 XA=2 XB=10 XC=16 20 X (units)
6
 Example: Individual Demand Curve for X
PX

The points found on the price consumption

curve produce the typically downward-sloping
demand curve we are familiar with.

PX = 4 •
PX = 2 •
PX = 1 • U increasing

X
XA=2 XB=10 XC=16 7
 5.2 Deriving the Demand Curve

Algebraically, we can derive an individual’s

demand using the following equations:

a) Pxx + Pyy = I (budget constraint)

b) MUx/Px = MUy/Py (tangency point)

1) Solve (b) for y

2) Substitute y from (b) into (a)
3) Solve for x
8
 General Example:

Suppose that U(x,y) = xy. MUx = y and MUy = x.

The prices of x and y are Px and Py, respectively and
income = I.
1) x/Py = y/Px
y = xPx/Py

2) Pxx + Py(Px/Py)x = I
Pxx + Pxx = I

3) x= I/2Px
9
 Specific Demand Example
Let U=xy, therefore MUx=y and MUy=x
Let income=12, Py=1.
Graph demand as Px increases from $1 to $2 to
$3.

Step 1: Pxx+Pyy=I
Pxx+y=12

Step 2: MUx/MUy=Px/Py
y/x=Px 10
 Demand Example
Step 1: Pxx+y=12

Step 2: y=Pxx

Step 3: Pxx+Pxx=12
x=6/Px

X(1)=6
X(2)=3
X(3)=2 11
 PX Demand Example

Maximizing at each point, we arrive at

the following demand curve:

PX = 3 •
PX = 2 • U increasing
PX = 1 •
X
2 3 6 12
 Y (units)
Demand, Choice and Income
At a given income, a consumer maximizes
using tangency as seen below:

10

I = 10
0 XA=2 XB=10 X (units)
13
 Y (units)
Demand, Choice, and Income

When income increases

the budget line shifts out,
resulting in a new
10
equilibrium
•
•

I=12
I = 10
0 XA=2 20 X (units)
14
XB=3
 Y (units) 5.3 The Income Consumption Curve

The income consumption curve for good

x plots all the utility maximization points
as income changes. This is shown by
shifting the demand curve for x.

10
Income consumption curve

•
• •

0 20 X (units)
15
 The Income Consumption & Demand Curves
Y (units)
I=92

I=68
U3

U2
Income consumption curve
I=40
U1

0 X (units)
10 18 24
PX

$2
I=40 I=68 I=92

10 18 24
X (units) 16
The income consumption curve for good x also
can be written as the quantity consumed of good
x for any income level. This is the individual’s
Engel Curve for good x.
When the income consumption curve is
positively sloped, the slope of the Engel
curve is positive.

17
I ($)

“X is a normal good”

Engel Curve
92

68

40

0 10 18 24 X (units)
18
• If the income consumption curve shows that the
consumer purchases more of good x as her income
rises, good x is a normal good.
• Equivalently, if the slope of the Engel curve is
positive, the good is a normal good.

• If the income consumption curve shows that the

consumer purchases less of good x as her income
rises, good x is an inferior good.
• Equivalently, if the slope of the Engel curve is
negative, the good is an inferior good.
19
• Some goods are normal or inferior over different
income levels
Example: Kraft Dinner
a) at extreme low incomes, Kraft dinner consumption
goes up as income increases (because starving is bad)
-Kraft Dinner is a normal good at extreme low
incomes
b) as income rises, people substitute away from Kraft
Dinner to “real foods”
-Kraft dinner is an inferior good at most
incomes
20
Y (units)
I=400

I=300 U3 A good can be normal over some

ranges and inferior over others
I=200 U2
U1

0 X (units)
13 16 18
I ($)

400 Example: Backward

Bending Engel Curve
300 Engel Curve

200

X (units) 21
13 16 18
5.5 Substitution and Income Effects
When the price of a good decreases, two
effects occur:
1) The good is cheaper compared to other
goods; consumers will substitute the
cheaper good for more expensive goods
2) Consumers experience an increase in
purchasing power similar to an increase
in income
22
 Definition: As the price of x falls, all else
constant, purchasing power rises. This is called
the income effect of a change in price.

 The income effect may be negative (normal

good) or positive (inferior good).

23
As the price of x falls, all else constant, good x
becomes cheaper relative to good y. This change in
relative prices alone causes the consumer to adjust
his/ her consumption basket. This effect is called the
substitution effect.
The substitution effect always is negative
Usually, a move along a demand curve will
be composed of both effects.
Graphically, these effects can be
distinguished as follows…
24
Y (units)
Example: Normal Good: Income and
Substitution Effects
BL2
BL1 Let Px decrease

A
• C

B
•
• U1
U2
BLd
Substitution

Income

0 X (units)
XA XB XC
25
Y (units) Example: Inferior Good: Income and Substitution
Effects
BL2 “X is an inferior good”

C
A • BL1

• U2

B BLd
• U1
Income
Substitution

0 XA XC XB X (units)
26
Finding the DECOMPOSITION Budget Line

The decomposition budget line (BLd) that

satisfies 2 conditions:
1) The budget line represents a change in
the price ratio; it must be parallel to the
new budget line (BL2)
2) The budget line must be tangent to the
old indifference curve (U1)
27
Y (units)
Budget line slopes
BL2 Slope of B1 = -Px1/Py
BL1
Slope of B2 = -Px2/Py

A Slope of Bd = -Px2/Py
• C
•
• B U2 BLd
Substitution U1
Income

0 X (units)
XA XB XC
28
 Steps to Finding Substitution and Income Effects:

1) Using initial prices (and tangency), find

a) start point (xa, ya)
b) start utility (Ua)

2) Using final prices (and tancency), find

a) end point (xc, yc)
b) end utility (Uc)
29
 Steps to Finding Substitution and Income Effects:

3) Using final prices and start utility for

a) decomposition point (xb, yb)

4) Solve:
a) Substitution Effect: xB-xA
b) Income Effect: xC-xB

30
31
 Solving for x:
x = 1/(Px2)
x = 1/(0.5)2
x=4

Substituting, xA = 4 into the budget constraint:

Pxx + Pyy = 10
0.5(4) + (1)y = 10
yA = 8
UA = 2xA1/2 +yA
UA=2(41/2)+8
UA=12
32
2) Suppose that px = $0.20. What is
the (final) optimal consumption basket?

Using the demand derived in (a),

x = 1/(Px2)
xc = 1/(0.2)2
xc = 25

Pxx + Pyy = 10
0.2(25) + (1)y = 10
yC =5

33
3) What are the substitution and income effects
that result from the decline in Px?
Decomposition basket (New Prices, Old Utility)

Tangency:
MUx/MUy = Px/Py 
1/x1/2 = .2
xb=25
U = 2x1/2 + y
12 = 2(25)1/2 + y
yB = 2
Substitution Effect: xB-xA = 25 - 4 = 21
Income Effect: xC-xB = 25 - 25 = 0
34
 Giffen Goods
If a good is so inferior that the net effect of a price
decrease of good x, all else constant, is a decrease in
consumption of good x, good x is a Giffen good.

For Giffen goods, demand does not slope down.

When might an income effect be large enough to

offset the substitution effect? The good would
have to represent a very large proportion of the
budget. (Some economists debate the existence of
Giffen Goods)
35
Y (units)
Example: Giffen Good: Income and
Substitution Effects
BL2
“X is a Giffen good”
C
• BL1
A U2
•
B
Income
• U1

Substitution

0 X (units)
XC XA XB
36
 The individual’s demand curve can be seen as the individual’s
willingness to pay curve.

 On the other hand, the individual must only actually pay the
market price for (all) the units consumed.

 For example, you may be willing to pay $40 for a haircut, but
upon arriving at the stylist, discover that the price is only $30

 The difference between willingness to pay and the amount

you pay is the Consumer Surplus
37
Definition: The net economic benefit to the
consumer due to a purchase (i.e. the willingness to
pay of the consumer minus the actual price) is
called consumer surplus.

The area under an ordinary demand curve and

above the market price provides a measure of
consumer surplus.

Note that a consumer will receive more surplus

from the first good than from the last good.
38
 Consumer Surplus
Consumer Surplus: The difference
Price
between what a consumer is willing to
pay and what they pay for each item
Consumer
Surplus
Equilibrium
P* Or market
Price

Q* Quantity39
Efficiency of the Equilibrium Quantity
Price Consumer Surplus = area of triangle
$16 =1/2bh
=1/2(16-8)(10)
=40
Consumer
Surplus (This calculation
Only works for
$8
A linear demand
curve)

10 Quantity40
 Consumer Surplus Example 1

Craig’s demand for model cars is given by the

demand curve P=20-Q. If model cars cost $10
each, how much consumer surplus does Craig
have?

P=20-Q
10=20-Q
10=Q, Craig buys 10 model cars

Consumer Surplus =1/2bh

=1/2(10)(20-10)
=50 41
 In practice, a consumer’s demand curve is difficult to
estimate

 Consumer Surplus can be estimated using the

optimal choice diagram (budget lines and indifference
curves)

 Since utility is difficult to measure, consumer

surplus is measured through the money needed when
a price change occurs:
42
COMPENSATING VARIATION: The minimum
amount of money a consumer must be compensated
after a price increase to maintain the original utility.

-The consumer’s ORIGINAL Utility is important.

EQUIVALENT VARIATION: The change in money to

give a equivalent utility to a price change.

-The consumer’s FINAL Utility is important.

43
Y (units) Compensating Variation
-A change in the price of x shifts BL1 to BL2
-Consumption moves from point A to point C
N -A BL at new prices that would maintain original
•A utility is parallel to BL2
C -NM represents the money
M
• U2 required to return a consumer to
B their original utility, consuming
• at B (if Py=1)
U1
BL2
BL1

O X (units)
44
Y (units) Equivalent Variation
Q
-A change in the price of x shifts BL1 to BL2
D
• -Consumption moves from point A to point C
-A BL at old prices that would make the equivalent
N
•A move to the new utility is parallel to BL1
C
• U2
-NQ represents the money
equivalent to a price change,
resulting in consumption at D
(if Py=1)
U1
BL2
BL1

O X (units)
45
Y (units) Compensating and Equivalent Variation
Q
-Here a price DECREASE
D occurs
N
• -MN is the max amount a
consumer would PAY for this
•A B price decrease
M • U2
-NQ is the amount a
consumer would be PAID
C
• instead of a price decrease
U1
BL2
BL1

O X (units)
46
 CV and EV Steps
1) Calculate ORIGINAL and NEW consumption
points that maximize utility. (Use tangency
condition.)
2) Calculate ORIGINAL and NEW utility.
3a) Compensating Variation:
With ORIGINAL UTILITY and NEW PRICES,
minimize expenditure ECV
CV=I-ECV
3b) Equivalent Variation:
With FINAL UTILITY and ORIGINAL PRICES,
minimize expenditure EEV 47

EV=E -I
 Consumer Surplus Example 2
Hosea’s utility demand for mini xylophones and
yogurt (x and y) is represented by U=x2+y2
MUx=2x MUy=2y.

Hosea has $20. Mini xylophones originally cost

$2 while yogurt cost $1. Due to an outbreak of
mad xylophone disease, price of healthy mini
xylophones decreased to $1 each.

Calculate compensating and equivalent variation.

48
 Consumer Surplus Example 2
Originally (at point A): After price change (at point C):
MUx/Px=MUy/Py MUx/Px=MUy/Py
2x/2=2y/1 2x/1=2y/1
2X=4Y X=Y
X=2Y
PxX+PyY=I
PxX+PyY=I X+Y=20
2X+Y=20 X=10
5Y=20
Y=4 X=Y
Y=10
X=2Y 49
 Consumer Surplus Example 2
Originally (at point A): After price change (at point C):
Y=4 X=10
X=8 Y=10

U(A) =42+82 U(B) =102+102

=16+64 =100+100
=80 =200
Decrease in price causes an increase in utility.

Here we have maximized utility given a budget

constraint.
50
Y (units) Compensating Variation
Compensating variation: at the new prices
(budget line parallel to the new budget
N line), minimize expenditure to achieve the
original utility (U1).
•A
C
M
• U2
B
•
U1
BL2
BL1

O X (units)
51
 Consumer Surplus Example 2
Compensating variation: at the new prices (budget line
parallel to the new budget line), minimize expenditure to
achieve the original utility.

MUx/Px=MUy/Py
2x/1=2y/1
X=Y

U=x2+y2
80=x2+x2
40=x2
401/2=x
401/2=y 52
 Consumer Surplus Example 2
Compensating variation: at the new prices (budget line
parallel to the new budget line), minimize expenditure to
achieve the original utility.

401/2=x
401/2=y

PxX+PyY=I
X+Y=I
2(401/2)=I
12.65=ECV
53
 Consumer Surplus Example 2
Compensating variation: the maximum amount a
consumer will pay to receive a price discount

CV=Original I-ECV
CV=20-12.65
CV=7.35

Hosea would pay a maximum of $7.35 to be able

to buy mini xylophones at a reduced price of $1.

54
Y (units) Equivalent Variation
Q
Given the old prices, minimize expenditure
D to achieve the new utility
•
N
•A
B
• U2

U1
BL2
BL1

O X (units)
55
 Consumer Surplus Example 2
Equivalent variation: at the old prices (budget line
parallel to the old budget line), minimize expenditure to
achieve the new utility.

MUx/Px=MUy/Py
2x/2=2y/1
X=2Y

U=x2+y2
200=4y2+y2
40=y2
401/2=y
2(401/2)=x 56
 Consumer Surplus Example 2
Equivalent variation: at the old prices (budget line
parallel to the old budget line), minimize expenditure to
achieve the new utility.

401/2=y
2(401/2)=x

PxX+PyY=I
2X+Y=I
2(2(401/2))+401/2=I
31.62=EEV
57
 Consumer Surplus Example 2
Equivalent variation: the minimum amount a
consumer would have to be paid to be as well off
as a price decrease

EV=EEV-Original I
EV=31.62-20
EV=11.62

Hosea would need to be paid $11.62 to be as

well off as a decrease in the price of xylophones.
58
Note that in the previous example CV did not equal EV
($7.35 is not equal to $11.62).
This occurs because the price change has a non-zero
income effect.
Although CV and EV try to approximate Consumer
surplus, generally neither will

However,
If the income effect is zero, CV=CS=EV
-ie: Quasi-Linear Utility functions.
59
COMPENSATING VARIATION:

Original Utility and new prices

EQUIVALENT VARIATION:
Final Utility and old prices
60
In the economy, each market has many individuals
demanding a good
Each individual maximizes their own utility when
deciding on the amount they will buy
Each individual has a maximum price they will pay
and a maximum amount of the item they would want
Ie: I’d pay $5 per episode of House, up to 20
episodes…how much would you pay?
The sum of individual demand creates market
demand 61
Consider the following individuals’ demand for Sushi:
Price $1 $2 $3 $4

Craig’s 8 6 4 2
Demand
Kristy’s 6 3 0 0
Demand
Total 14 9 4 2
Demand 62
Price
Market Demand

Here the individual demand

curves (DK and DC) combine
to form market demand
(DM).

$4 •
DK DC
$2 • • •
DM

O 6 9 63
2 3 Sushi
Algebraically the demand curves are as follows:
10  2 P when P  5
QC ( P)  {
0 when P  5
9  3P when P  3
Qk ( P)  {
0 when P  3
These combine to give us :
19  5 P when P  3
Qm ( P)  {10 - 2P when 3  P  5
0 when P  5 64
Price
Market Demand
In section A of market demand, Qm=Qc+QK.
(it is important to add the normal form:
Q=f(P), not the inverse form: P=f(Q).)
In section B of market demand, Qm=QC.

$4 •
$2 • • •
DM

DK DC
O 6 9 65
2 3 Sushi
P P P
Q = 10 - p
10
Q = 10 - p Q = 20 - 5p Q = 30 - 6p
4

Q Q Q
Consumer 1 Consumer 2 Aggregate demand

Note that at a price of $4,

10-p=30-6P=6 66
 Basic economic theory states that as an individual’s
wage increases they will work more; the benefit from
an additional hour of work outweighs the benefit from
an additional hour of watching TV (House of course)

 In practice however, high wage earners tend to work

less than minimum wage earners

 Is this the end of economics as we know it?

67
Assume:
“Labor” includes all work hours when the consumer is
earning income. (L hours per day at wage rate w per
hour. Let w = $5)

“Leisure” includes all nonwork activities

(so hours of leisure, l = 24 – L)

U= U(y,l)

Utility depends on consumption of a composite good (y)

and hours of leisure.

68
The composite good, y, has price py = $1

•Daily income = wL
The budget line gives all the combinations of y
and l that the consumer can afford.

If l = 24, y = 0
If l = 0, y = 120
Slope of budget line is -$5.
max U  U ( y, l )
l

s.t. 24  L  l
s.t. y  Lw 69
Y (units) Labour and Leisure
600
w=25
As wage is increasing, a consumer’s
maximization may cause him/her to increase
480 w=20 or decrease leisure:

360 w=15

w=10
240
••
120
w=5
•
•
•
O
Leisure (l) 70
The substitution effect leads to less leisure
and more labor as w increases.

As w increases, the consumer has more

income (less work is needed to buy a unit of y).
This creates an income effect.

If leisure is a normal good, the income

effect on leisure is positive

Therefore, the income effect on labor is

negative (labor is a “bad”) 71
This information can be used to construct
the consumer’s labor supply function, L(w).
If the substitution effect of a wage
increase outweighs the income effect,
the labor supply slopes upwards

If the income effect of a wage

increase outweighs the substitution
effect, the labor supply curve bends
backwards.
72
 Daily Income in units of composite good, Y
600 Example: A Backward Bending Supply of
Labor
W=25
480 Wage increases from $15 to
$25, causing an increase in
360
U5 leisure time

U3
•C
240 W=15 B
• •A
Income
120

•24
Substitution

12 13 14 15 Leisure (hours)
Substitution Effect (LB-LA) Income Effect (LC-LB) 73
 Chapter 5 Key Concepts
Deriving Demand
Price Consumption Curve
Demand Curve
Income Consumption Curve
Engel Curve
Substitution and Income Effects
Decomposition Budget Line
Consumer Surplus
74
 Chapter 5 Key Concepts
Compensating & Equivalent Variation
Market Demand
Labor and Leisure
Backwards Bending Labor Supply

75