Chapter 4
Slide 1
a) How would an increase in the price of gasoline
affect a consumer’s budget line? (twoo good gasoline and clothes)
b) Think about consumers response to the rise in gasoline prices

Chapter 4
Slide 2
Last time…
nTheory of consumer behavior
lHow rational consumers decide on the optimal combination of goods to consume with their limited
budget in order to maximize their total utility at any given time.
l
l

Chapter 4
Slide 3
Last time…
lEvery consumer behaves rationally: Consumers try to get the "most for their money" to maximize
their total utility
l
lEvery consumer has different preferences: Consumers have clear cut preferences and can determine
how much marginal utility they get from consuming more units of a product
l
lEvery consumer is under a budget constraint: All consumers face a budget constraint, therefore
must make decisions about what they buy based on their limited budget
l
lEvery product has a price: Every product has a price, so consumers must weigh their purchasing
decisions based on their marginal utility from consumption and the price of the goods they consume
l
l

Chapter 4
Slide 4
Exercise 2
lIC with perfect substitutes
l

Chapter 4
Slide 5
Exercise 3
lIC with perfect complements
l

Chapter 4
Slide 6
Exercise XY
l
nIncome of I  $800 per month, the price of food is PX  $20 per unit, and the price of clothing is
PY $40 per unit.
nBudget line?
n

Chapter 4
Slide 7
Exercise XY

Chapter 4
Slide 8
Interior optimum
l
nThe optimum occurs at a point where the budget line is tangent to the indifference curve. In other
words, at an interior optimal basket, the consumer chooses commodities so that the ratio of the
marginal utilities (i.e., the marginal rate of substitution)
n
n
n
nat an interior optimal basket, the consumer chooses commodities so that the marginal utility per
dollar spent on each commodity is the same.
n

Chapter 4
Slide 9
Corner point
l
nInterior optimum= consumer purchases positive amounts of both goods
nHowever, in reality, though, a consumer might not purchase positive amounts of all available goods
(some consumers may not spend money on tobacco or alcohol)
nSolution= optimal basket at a corner point, that is, at a basket along an axis, where one or more
of the goods is not purchased at all (the budget line may not be tangent to an indifference curve
at the optimal basket).
n
n
n

Chapter 4
Slide 10
Corner point

Chapter 4
Slide 11
Exercise XY
l
nutility function U(x, y)=xy +10x and income=10. Px = $1 and a price of clothing Py = $2.
nOptimal basket?
n

Chapter 4
Slide 12
Exercise XY
n

Chapter 4
Slide 13
Individual Demand: Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U2
U3
A
B
D
U1
4
12
20
Three separate
indifference curves
are tangent to
each budget line.
Assume:
•I = $20
•PC  = $2
•PF  = $2, $1, $.50
10

Chapter 4
Slide 14
Price-Consumption Curve
Individual Demand: Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U2
U3
A
B
D
U1
4
12
20
The price-consumption
curve connect all of the baskets that are optimal as the price of food changes (price of clothing
and income are constant)

Chapter 4
Slide 15


Chapter 4
Slide 16
Individual Demand: Effect of a Price Change
n1) The level of utility that can be attained changes as we move along the curve.
n2) At every point on the demand curve, the consumer is maximizing utility by satisfying the
condition that the MRS of food for clothing equals the ratio of the prices of food and clothing.
The Individual Demand Curve: 2 Important
Properties

Chapter 4
Slide 17
Individual Demand: Effect of a Price Change
Food (units
per month)
Price
of Food
H
E
G
$2.00
4
12
20
$1.00
$.50
Demand Curve
•E: Pf /Pc = 2/2 = 1 = MRS
•G: Pf /Pc = 1/2 = .5 = MRS
•H:Pf /Pc = .5/2 = .25 = MRS
When the price falls: Pf /Pc & MRS also fall

Chapter 4
Slide 18
Individual Demand: Effect of Income Changes
Food (units
per month)
Clothing
(units per
month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
Income-Consumption
Curve
3
4
A
U1
5
10
B
U2
D
7
16
U3
Assume: Pf  = $1
  Pc  = $2
                I = $10, $20, $30

Chapter 4
Slide 19
Individual Demand: Effect of Income Changes
Food (units
per month)
Price
of
food
An increase in income,
from $10 to $20 to $30,
with the prices fixed,
shifts the consumer’s
demand curve to the right.
$1.00
4
D1
E
10
D2
G
16
D3
H

Chapter 4
Slide 20


Chapter 4
Slide 21
Individual Demand: Effect of Income Changes
nIncome Changes
lWhen the income-consumption curve has a positive slope, the quantity demanded increases with
income; the income elasticity of demand is positive. The good is a normal good.
lWhen the income-consumption curve has a negative slope, the quantity demanded decreases with
income; the income elasticity of demand is negative. The good is an inferior good.
l
Normal Good vs. Inferior Good

Chapter 4
Slide 22
Individual Demand: Effect of Income Changes with an Inferior Good
Hamburger
 (units per month)
Steak
(units per
month)
15
30
U3
C
Income-Consumption
Curve
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C.
10
5
20
5
10
A
U1
B
U2
Both hamburger
and steak behave
as a normal good,
between A and B...

Chapter 4
Slide 23
Individual Demand: Effect of Income Changes
nEngel Curves
lEngel curves relate the quantity of good consumed to income.
lIf the good is a normal good, the Engel curve is upward sloping.
lIf the good is an inferior good, the Engel curve is downward sloping.

Chapter 4
Slide 24
Engel Curves: Normal Good
Food (units
per month)
30
4
8
12
10
Income
($ per
month)
20
16
0
Engel curve slopes
upward for a
normal good.

Chapter 4
Slide 25
Engel Curves: Inferior Good
Engel curve is
backward bending
 for inferior goods.
Inferior
Normal
Food (units
per month)
30
4
8
12
10
Income
($ per
month)
20
16
0

Chapter 4
Slide 26
Individual Demand: Substitutes and Complements
1)Substitute goods: an increase (decrease) in the price of one leads to an increase (decrease) in
the quantity demanded of the other. E.g. movie tickets and video rentals
2)Complements: an increase (decrease) in the price of one leads to a decrease (increase) in the
quantity demanded of the other. E.g. gasoline and motor oil
3)Two goods are independent when a change in the price of one good has no effect on the quantity
demanded of the other.

Chapter 4
Slide 27
Income and Substitution Effects
nA fall in the price of a good has two effects:
nSubstitution Effect: consumers will tend to buy more of the good that has become relatively
cheaper, and less of the good that is now relatively more expensive.
nIncome Effect: consumers experience an increase in real purchasing power when the price of one
good falls.

Chapter 4
Slide 28
Substitution Effect
lThe substitution effect is the change in an item’s consumption associated with a change in the
price of the item, with the level of utility held constant. lWhen the price of an item declines,
the substitution effect always leads to an increase in the quantity of the item demanded.

Chapter 4
Slide 29
Income Effect
lThe income effect is the change in an item’s consumption due to an increase in purchasing power,
with the price of the item held constant.
lIf income increases, the quantity demanded for the product may increase or decrease. Even with
inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

Chapter 4
Slide 30
Income and Substitution Effects: Normal Good
Food (units
per month)
O
Clothing
(units per
month)
R
F1
S
C1
A
U1
The income effect, EF2,
( from D to B) keeps relative
prices constant but
increases purchasing power.
Income Effect
C2
F2
T
U2
B
When the price of food falls, consumption increases by F1F2  as the consumer moves from  A to B.
E
Total Effect
Substitution
Effect
D
The substitution effect,F1E,
(from point A to D),  changes the
relative prices but keeps utility
(satisfaction) constant.

Chapter 4
Slide 31
Food (units
per month)
O
R
Clothing
(units per
month)
F1
S
F2
T
A
U1
E
Substitution
Effect
D
Total Effect
As food is an inferior good
in this example, the income
effect is negative.  However,
the substitution effect is
larger than the income effect.
B
Income Effect
U2
Income and Substitution Effects: Inferior Good

Chapter 4
Slide 32
Exercise XY
lSuppose a consumer’s preferences between two goods (x and y) can be represented by the utility
function U=xy, Income is 72, Py=1, Px1=9 and Px2=4
lcompute MUx and MUy
lFind the numerical values of the income and substitution effects on food consumption and graph the
results
l

Chapter 4
Slide 33


Chapter 4
Slide 34
From Individual to Market Demand: Determining the Market Demand Curve
n1 6 10 16 32
n2 4 8 13 25
n3 2 6 10 18
n4 0 4 7 11
n5 0 2 4 6
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)

Chapter 4
Slide 35
Summing to Obtain a Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5
10
15
20
25
30
DB
DC
Market Demand
DA
The market demand
curve is obtained by
summing the consumer’s
demand curves

Chapter 4
Slide 36
Market Demand: Elasticity
nElasticity of Demand
lRecall: Price elasticity of demand measures the percentage change in the quantity demanded
resulting from a
l 1% change in price.

Chapter 4
Slide 37
Price Elasticity and Consumer Expenditure
n Demand If Price Increases, If Price Decreases,
n Expenditures: Expenditures:
Inelastic (Ep <1) Increase Decrease
Unit Elastic (Ep = 1) Are unchanged Are unchanged
Elastic (Ep >1) Decrease Increase

Chapter 4
Slide 38
Market Demand: Elasticity
nPoint Elasticity of Demand
lPoint elasticity measures elasticity at a point on the demand curve.
lFor large price changes (e.g. 20%), the value of the elasticity will depend upon where the price
and quantity lie on the demand curve.
lProblem: we may need to calculate price elasticity over a portion of the demand curve rather than
at a single point. The price and quantity used as the base will alter the price elasticity of
demand.

Chapter 4
Slide 39
Market Demand: Elasticity
nAssume
lAs price increases from $8 to $10, the quantity demanded falls from 6 to 4
lPercent change in price equals: $2/$8 = 25% or $2/$10 = 20%
lPercent change in quantity equals: -2/6 = -33.33% or -2/4 = -50%
nElasticity equals: -33.33/25 = -1.33 or -50/20 = -2.5
nWhich one is correct?
l
Point Elasticity of Demand (An Example)

Chapter 4
Slide 40
Market Demand: Elasticity
nArc Elasticity of Demand
lArc elasticity calculates elasticity over a range of prices
lIts formula is:

Chapter 4
Slide 41
Market Demand: Elasticity
nArc Elasticity of Demand (An Example)

Chapter 4
Slide 42
An Example: Aggregate Demand For Wheat
nThe demand for US wheat is comprised of domestic demand and export demand.
nThe domestic demand for wheat is given by:
lQDD = 1700 - 107P
nThe export demand for wheat is given by:
lQDE = 1544 - 176P
nDomestic demand is relatively price inelastic       (-0.2), while export demand is more price
elastic (-0.4).
l

Chapter 4
Slide 43
C
D
Export
Demand
A
B
Domestic
Demand
Total world demand is
the horizontal sum of the
domestic demand AB and
export demand CD.
F
Total Demand
E
The Aggregate Demand For Wheat
Wheat(million bushels/yr.)
Price
 ($/bushel)
0
2
4
6
8
10
12
14
16
18
20
1000
2000
3000
4000

Chapter 4
Slide 44
Consumer Surplus
nConsumer Surplus: the difference between the maximum amount a consumer is willing to pay for a
good and the amount actually paid.
nCombining consumer surplus with the aggregate profits that producers obtain we can evaluate:
n 1) Costs and benefits of different market structures
n 2) Public policies that alter the behavior of consumers and firms

Chapter 4
Slide 45
The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
        Consumer Surplus
    6    +  5   +   4   +  3    +   2  +  1   = 21
Consumer Surplus
Rock Concert Tickets
Price
 ($ per
ticket)
2
3
4
5
6
13
0
1
14
15
16
17
18
19
20
Market Price

Chapter 4
Slide 46
Demand Curve
Consumer
Surplus
Actual
Expenditure
Consumer Surplus
for the Market Demand
Consumer Surplus
Rock Concert Tickets
Price
 ($ per
ticket)
2
3
4
5
6
13
0
1
14
15
16
17
18
19
20
Market Price

Chapter 4
Slide 47
Network Externalities
nUp to this point we have assumed that people’s demands for a good are independent of one another.
nIn fact, a person’s demand may be affected by the number of other people who have purchased the
good. If this is the case, a network externality exists.

Chapter 4
Slide 48
Positive Network Externalities
nPositive network externality: the quantity of a good demanded by a consumer increases in response
to an increase in purchases by other consumers.
nThe Bandwagon Effect
lThis is the desire to be in style, to have a good because almost everyone else has it, or to
indulge in a fad.
lThis is the major objective of marketing and advertising campaigns (e.g. toys, clothing).

Chapter 4
Slide 49
Demand
Positive Network Externality: Bandwagon Effect
Quantity
 (thousands per month)
Price
($ per
unit)
D20
20
40
60
80
100
D40
D60
D80
D100
The market demand
curve is found by joining
the points on the individual
demand curves.  It is relatively
more elastic.

Chapter 4
Slide 50
Demand
Positive Network Externality: Bandwagon Effect
Quantity
 (thousands per month)
Price
($ per
unit)
D20
20
40
60
80
100
D40
D60
D80
D100
Pure Price
Effect
$20
Bandwagon
Effect
Suppose the price falls
from $30 to $20. With no
bandwagon effect, Qd
would increase to 48,000
only. But as more people
buy the good, it becomes
stylish to own it and Qd
increases further.
$30
48

Chapter 4
Slide 51
Negative Network Externalities
nIf the network externality is negative, a snob effect exists = the desire to own exclusive or
unique goods.
nThe quantity demanded of a “snob” good is higher the fewer the people who own it.

Negative Network Externality: Snob Effect
Quantity  (thousands
per month)
Price
($ per
unit)
Demand
2
D2
$30,000
$15,000
14
Pure Price Effect
Originally demand is D2,
when consumers think 2000
 people have bought a good.
4
6
8
D4
D6
D8
However, if consumers think 4,000
 people have bought the good,
demand shifts from D2 to D4 and  its
 snob value has been reduced.

Negative Network Externality: Snob Effect
Quantity  (thousands
per month)
2
4
6
8
Demand is less elastic and
 as a snob good, its value is greatly
reduced if more people own
it. Sales decrease as a result.
Examples: Rolex watches and long
 lines at the ski lift.
Price
($ per
unit)
D2
$30,000
$15,000
14
D4
D6
D8
Demand
Pure Price Effect
Snob Effect
Net Effect