Topic 5

Demand

I have enough money to

last me the rest of my
life, unless I buy
something.
Jackie Mason

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Topic 5 Outline
4.1 Deriving Demand Curves
4.2 Effects of an Increase in Income
4.3 Effects of a Price Increase

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Motivating example: Paying Employees
to Relocate
• Background:
– International firms are increasingly relocating workers
throughout their home countries and internationally.
– Firms must decide how much compensation to offer
workers to move.

• Question:
– Do firms’ standard compensation packages
overcompensate workers by paying them more than
necessary to induce them to move to a new location?

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4.1 Deriving Demand Curve
• Ceteris paribus, a change in the price of a good will cause
a movement along the demand curve.
• As we saw this in topic 2:

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4.1 Deriving Demand Curves
• In topic 4, we used calculus to maximize consumer utility
subject to a budget constraint.
– This results is finding the consumer’s system of
demand functions for the goods.
• Example: q1 = pizza and q2 = burritos
– Demand functions express these quantities in terms of
the prices of both goods and income:
q1 Z ( p1, p2 ,Y )
q2 B( p1, p2 ,Y )
– Given a specific utility function, we can find closed-form
solutions for the demand functions.
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4.1 Example: Deriving Demand Curves
• Constant Elasticity of Substitution (CES) utility function:
1

U (q1, q2 ) (q1  q ) , 0  1
 
2

• Budget constraint:
Y  p1q1  p2q2
• With the techniques in topic 4, we obtain the demand
functions resulting from this constrained optimization
problem:
Yp1  Yp2 
q1  1  1  q2  1 
p1  p2 p1  p21 

• Demand is a function of prices and income.

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4.1 Example: Deriving Demand Curves
• Cobb-Douglas utility function:
U (q1, q2 ) q1aq21 a

• Budget constraint:
Y  p1q1  p2q2
• Thee demand functions that result from this constrained
optimization problem are:
Y Y
q1 a q2 (1  a )
p1 p2
• With Cobb-Douglas utility, demand of a good is a function of
only the good’s own-price and income.
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4.1 Deriving Demand Curves
• Figure below shows the demand curve under Cobb-Douglas
preferences, i.e. q1= aY/p1, holding Y fixed and varying p1.

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4.1 Deriving Demand Curves
• Figure below shows the demand curve under perfect
substitutes preferences when i = j =1, holding Y fixed and
varying p1.

MRS = 1 < p1/ p2 so q1* = 0

MRS = 1 = p1/ p2 so 0 ≤ q1* ≤ Y/ p1

MRS = 1 > p1/ p2 so
q1* = Y/ p1

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4.1 Demand Functions for Five Utility
Functions

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4.1 Deriving Demand Curves Graphically
• As the price of beer falls, the MRT changes and the budget constraint
pivots out around the point where the consumer only buys the other
good.

– This traces
out the
points along
the demand
curve.

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4.2 Effects of a
Budget Increase
• Income increases do not
change the MRT
• The budget set expands
through a series of parallel
shifts.
– This traces out points
along the Engel curve.

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4.2 Effects of a Budget Increase: An
example
• Mahdu views Coke and Pepsi as perfect substitutes. In
addition, he likes them equally.
• The price of a can of Coke, p, is less than the price of a
can of Pepsi, p*.
– What does Mahdu’s Engel curve for Coke look like?
– How much does his weekly cola budget have to rise for
Mahdu to buy one more can of Coke per week?

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4.2 Effects of a
Budget
Increase: An
example
• As Mahdu’s
income increases,
the budget
constraint shifts
out
– This traces out
points along
the Engel
curve in.

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 Quasi-linear Indifference Curves

x2 Each curve is a vertically shifted

copy of the others.
Each curve intersects
both axes.

x1
Income Changes; Quasilinear
Utility
x2

x1
~
x1
Income Changes; Quasilinear
Utility
x2

y Engel
curve
for
good 1
x1 ~ x1*
x1
~
x1
Income Changes; Quasilinear
Utility y Engel
x2 curve
for
good 2
x2*

x1
~
x1
Income Changes; Quasilinear
Utility y Engel
x2 curve
for
good 2
x2*
y Engel
curve
for
good 1
x1 ~ x1*
x1
~
x1
4.2 Effects of an Increase in Income
• An increase in an individual’s income, ceteris paribus,
causes a shift of their demand curve.
– An expansion of demand (a shift away from the origin)
if the good is a normal good
– A contraction (a shift toward the origin) if the good is
inferior.
• A change in income prompts the consumer to choose a
new optimal bundle.
• The result of the change in income and the new utility
maximizing choice can be depicted in three different ways.

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4.2 Effects of an Increase in Income

1. Income-consumption curve: using the consumer

utility maximization diagram, connects optimal
consumption bundles as income varies

2. Shifts in demand curve: using the demand diagram,

shows how quantity demanded changes for a given
price of the good

3. Engel curve: shows the relationship between income

and quantity demanded [positive for normal goods,
inverse for inferior]

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 4.2 Consumer Theory and Income
Elasticities
• Recall the income elasticity of demand from topic 3:
percentage change in quantity demanded Q / Q Q Y
“xi”   
percentage change in income Y / Y Y Q

• Normal goods, have a positive income elasticity.

– Luxury goods are normal goods with an income

elasticity greater than 1.
– Necessity goods are normal goods with an income
elasticity between 0 and 1.
• Inferior goods (no value judgment intended) have a
negative income elasticity

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4.2 Examples of Income Elasticities
• Some of the better-known examples of inferior goods are
starchy foods such as potatoes and cassava, which very
poor people eat in large quantities because they are cheap
but nutritious
• Bezmen and Depken (2006) estimated that pirated goods
are inferior: A 1% increase in per capita income leads to a
0.25% reduction in piracy
• Income elasticity for beer is 0.88 and that for wine is 1.38,
according to estimates for the average American consumer

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Your turn
• Suppose that an individual allocates his or her entire
budget between two goods, food and clothing. Can
both goods be inferior?

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4.2 Income-Consumption Curve and
Income Elasticities
• The shape of the income-consumption curve (ICC) for two
goods tells us the sign of their income elasticities.

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4.2 Income-Consumption Curve and
Income Elasticities
• Some goods can be both
normal and inferior,
depending on an
individual’s income level
– E.g. Fast-food meals.

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4.3 Effects of a Price Increase
• Ceteris paribus, an increase in the price of a good has two
effects on an individual’s demand, one obvious, the other
not so much:
1. Substitution effect: the consumer substitutes away
from the now more expensive good.
2. Income effect: the consumer’s purchasing power has
decreased.
Why? They would need more income to buy the
same bundle as before
• The total change in quantity demanded is the sum of the
substitution and income effects.

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4.3 Income and Substitution Effects
• The direction of the substitution effect is always negative.
– When the price increases, individuals consume less of
the now more expensive good
• The direction of the income effect depends upon whether
the good is normal or inferior
– When the good is normal, the income effect is negative

– When the good is inferior, the income effect is

positive
• When the income and substitution effect go in opposite
directions the total effect is ambiguous

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4.3 Income and Substitution Effects: An
example
• Jackie’s choice between music tracks and live music:
• U = q10.4q20.6 ; live music p2 = £1, music tracks p1 = £0.5
• Suppose the price of music tracks rises to £1 => Jackie’s
budget constraint pivots inward
• Jackie’s opportunity set is smaller; she has fewer bundles
of music tracks and live music to chose from
• Because her utility is Cobb-Douglas we know

• Her optimal bundle before the price rise is q1*=24 and

q2*=18, and after is q1**=12, q2**=18.
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4.3 Income and Substitution Effects: An
example
• The decrease in q1 from 24 to 12 is the total effect from the
rise in the price of music tracks
• We can decompose the total effect into a substitution effect
and an income effect
• One method for doing this is to clean the income effect by
compensating Jackie income so her utility stays constant
• Then we find her quantity demanded under this
compensated change in the price.
• The income effect is the difference holding the prices
constant

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4.3 Income and Substitution Effects: An
example
• Beginning from budget
constraint , an
L 1

increase in the price of

music tracks rotates
budget constraint into
L2 .
– The total effect of this
price change, a
decrease in quantity of
12 tracks per quarter,
can be decomposed
into income and
substitution effects
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4.3 Income and Substitution Effects: An
example
• Because the income effect is negative, we can infer that
music tracks is a normal good
• In addition, that means the total effect is unambiguously
negative: Jackie buys fewer music tracks when their price
rises
• But what
about live music?

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4.3 Another example: Income Effect
with Perfect Complements
• Kathy loves having apple pie à la mode (with one scoop of
vanilla ice cream on top). That is, she consumes apple pie
and vanilla ice cream in fixed proportions
• At the initial prices, she consumed two pieces of pie per
week
• After the price of pie rises, she chooses to consume only
one piece of pie
• Let’s show on a graph the substitution, income, and total
effects of the price change

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4.3 Another example: Income Effect
with Perfect Complements
• Beginning from budget
constraint L1, an
increase in the price
of pie rotates budget
constraint into
L2 .
– The total effect of this price
change with perfect
complements equals the
income effect
– With perfect complements
there is no substitution
effect
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4.3 Income and Substitution Effects
with an Inferior (Giffen) Good
• If a good is inferior, the income effect and the substitution
effects move in opposite directions
• For most inferior goods, the income effect is smaller than
the substitution effect, so the total effect remains negative,
i.e. the demand decreases when the price increases
• However, for Giffen goods, the income effect more than
offsets the substitution effect and demand increases when
the price increases
• Let’s see this at work in the case of Ximing, who spends
his money on rice, an inferior good, and all other goods.

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4.3 Income and Substitution Effects
with an Inferior (Giffen) Good
• Beginning from budget
constraint L , a
1

decrease in the price

of rice pivots the
budget constraint into
L2 .
– The total effect of this
price change is a
decrease in the
demand of rice because
the negative income
effect outweighs the
substitution effect

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Your turn
• Place the following goods in the table below according to
the size of the income and substitution effect you would
expect after a price increase
Income effect
Small Large

Small
Substitution
effect
Large

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Compensated Demand Curve
• We have constructed a demand curve by seeing how the
quantity purchased changes as the product price
changes while allowing utility to vary
• This is sometimes called the Marshallian demand curve, or
the uncompensated demand curve.
• Alternatively, we could derive the compensated demand
curve by holding utility constant as the price changes, so
that the change in the quantity demanded reflects only the
pure substitution effect
• This is also called the Hicksian demand curve

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Hicksian Demand Curve

• We cannot observe the compensated demand curve

directly because we do not observe utility levels
• Because the compensated demand curve reflects only
substitution effects, the Law of Demand must hold: The
compensated demand for a good is decreasing in its price
• One way to derive the compensated demand curve is to
use the expenditure function where E is
the smallest expenditure that allows the consumer to
achieve utility level given market prices.

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Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Compensated Demand Curve: An
example
• Consumer with Cobb-Douglas utility U = q1a q21 - a
• We’ll use the Lagrange method to solve the expenditure-
minimizing problem:

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• FOCs

• Use the first two to obtain

• Plugging this back

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Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Going back to our compensated
demand question

• In the particular case a = 0.4

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Motivating example solution
• Relocate from Seattle to London
• Budget line in Seattle is Ls
Worker buys s. Utility is I .
1

• Housing is relatively more

expensive in London. Budget
line L .is steeper
L

• Worker consumes l and

utility is I .
2

• Firm just needs to compensate

the worker with L* to induce
them to move. Worker
consumes l* and utility is I 1.
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