econ notes 1

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EC10C Lecture Notes Unit 3 Part 3

In this section of the Lecture Notes we look at the :

1. Income Consumption Curve and the Engel Curve.

2. Price Consumption Curve and the Derivation of the DemandCurve from the Price Consumption Curve.

3. Decomposition of the Total Price Effect in to the Income andSubstitution Effects for the cases of Normal, Inferior and Giffengoods.

4. The difference between individual demand and market demand.



The Theory of the Consumer (Cont’d)

The Income Consumption Curve

This curve shows the different consumer equilibria which result aswe change the consumer’s income while holding the prices of the

two goods constant.

Good Y

Good X0

The IncomeConsumptionCurve

BL 1 BL 2 BL 3

IC 1

IC 2

IC 3




The Engel Curve can be derived from the points alongthe Income Consumption Curve.

The Engel curve shows the relationship between theamount of the good that is bought and income.

The Engel curve for normal goods is upward slopingwhich denotes a positive relationship between demandfor the good and income.

The Engel curve for an inferior good is downward slopingwhich means that if income increases, then the demandfor that good falls and vice versa.




Panel A shows the Engel curve for a normal good, while panel B showsthe Engel curve for an inferior good.

0 0

Income Income

(A) Normal Good (B) Inferior Good

Good X orGood Y

EngelCurve

EngelCurve

Good X orGood Y




The Price Consumption Curve

This curve shows the different consumer equilibria which result as wechange one of the prices (the price of good X) while holding income andthe price of the other good (good Y) constant.

Good Y

The PriceConsumptionCurve

Good XBL1

BL2

BL3

IC 1

IC 2

IC 3




We can derive the demand curve from the points alongthe price consumption curve.

The higher prices along the demand curve correspond tothe tangency points which are closer to the point of originon the graph showing the price consumption curve andthe various consumer equilibria.

The following graph shows this derivation:




0

Good Y

The PriceConsumption Curve

Good XBL 1 BL 2 BL 3

IC 1

IC 2

IC 3

0

0

P1

Price

Quantity

Demanded

P2

P3

X1 X2 X3

DemandCurve




The Decomposition of the Total Price Effect (TPE)

The Income and Substitution Effects Revisited

The Income effect is the change in the purchasing power ofincome (or real income) that occurs when the price of oneof the good changes.

The Substitution effect occurs when the change in price ofone of the goods (while holding the other good’s price and

income constant) results in a change in the quantity that isdemanded of that good whose price changed.




We will break up the total price effect (TPE) into the substitution andincome effects. Thus TPE = SE + IE

The substitution effect (SE) is always negative. This means that theprice of a good and the quantity that is consumed of it (or bought) willalways move in opposite directions.

Normal Goods: The income effect (IE) is positive for normal goods. Thismeans that an increase in real income (or purchasing power) will

increase the amount of that good which is bought.

Inferior Goods: The income effect is always negative for inferior goods.This means that an increase in real income (or purchasing power) willreduce the amount of the good that is bought.




Giffen Good: If the price of a Giffen good increases, thenthe quantity demanded of that good also increases.

Giffen goods are usually goods whose prices are seen asbeing an indicator of their value, for example pieces of art.

The income effect for Giffen goods is also negative.

Now we will consider some fundamental rules:




1. For normal goods, the substitution effect is reinforcedby the income effect. In other words, the SE and IE havethe same impact on the quantity of the good that is bought.

2. For inferior goods, the substitution effect will be largerthan the income effect, i.e. SE > IE.

3. For Giffen goods, the income effect is larger than thesubstitution effect, i.e. IE > SE.

We will break down the total price effect for all three typesof goods when the price of good X decreases.




The effect of a decrease in the price of normal good on the quantity ofthat good that is consumed.

Normal Good

SE and IE have the same impact on the quantity consumed of the good.

SE:

IE:

TPE:

P is price, Q is quantity that is consumed of the good and RI is realincome (or the purchasing power of income).

QP

Q RI P

QP




Normal Good

0

Good Y

Good X

1

2

3

A

A’

B B’ C

IC 1

IC 2

X’ X*2X*1




Normal Good (Cont’d)

Our initial consumer equilibrium is at 1, where the originalbudget line AB forms a tangent to the indifference curve IC

1. A decrease in the price of the good X will mean that moreof that good can be purchased.

The move from 1 to 2 is the substitution effect. The

substitution effect is shown by dashed budget line A’B’,which holds real income (purchasing power) constant. Thebudget line A’B’ keeps us on the same indifference curve IC

1. The substitution effect says that if the price of a good fallsthen persons will switch to consuming more that good.




Normal Good (Cont’d)

The move from 2 to 3 is the income effect. The budget line

AC does not hold purchasing power constant. The incomeeffect is where the decrease in price increases thepurchasing power of the consumer. This increase inpurchasing power means that the consumer can now move

to a higher indifference curve IC 2 and budget line AC, andconsume more of the good.

The total price effect is the move from 1 to 3, which is the

sum of the substitution and income effects.




The effect of a decrease in the price of an inferior good (good X) on thequantity of that good that is consumed.

Inferior Good

SE:

IE:

TPE:

IE SE

QP

Q RI P

QP




Inferior Good

0

Good Y

Good X

A

A’

B B’ C

X’ X*2

IC 2

IC 1

1

2

3




Inferior Good (Cont’d)

The original equilibrium is at 1, where the budget line ABforms a tangent to the indifference curve IC 1.

The substitution effect is from 1 to 2 and the dashed budget

line A’B’ keeps real income constant. Although it is aninferior good, the substitution effect will mean that thedecrease in price will still result in an increase in quantitydemanded.




Inferior Good (Cont’d)

The move from 2 to 3 is the income effect. Although the

price has decreased and real income has increased, there isa reduction in the quantity consumed of the inferior gooddue to the negative income effect.

The income effect is dominated by the substitution effectand so the decrease in the price of the good will have thetotal price effect of an increase in the quantity that isconsumed of the inferior good.




The effect of a decrease in the price of the Giffen good on the quantity of

that good that is consumed.

Giffen Good

SE:

IE:

TPE:

SE IE

QP

Q RI P

QP




Giffen Good

0

Good Y

Good X

1

2

3A

A’

B B’ C

IC 2

IC 1

X*1 X’ X*2




Giffen Good (Cont’d)

The initial equilibrium is at 1, where the budget line ABforms a tangent to the indifference curve IC 1. The

substitution effect is from 1 to 2. The real income is heldconstant with the dashed budget line A’B’ and the same

indifference curve IC 1.

The income effect is from 2 to 3. The income effect isnegative for the Giffen good. The increase in real incomefrom the decrease in price will reduce the demand for theGiffen good.




Giffen Good (Cont’d)

The income effect outweighs the substitution effect, so the

decrease in the price of the Giffen good results in areduction in the quantity consumed of that good.

This result is in keeping with the definition of a Giffen good -

price and quantity demanded move in the same direction.




The effect of an increase in the price of normal good on the

quantity of that good that is consumed

Normal Good

SE and IE have the same impact on the quantity of the good.

SE:

IE:

TPE:

P is price, Q is quantity that is consumed of the good and RI is realincome (or the purchasing power of income).

QP

Q RI P

QP




The effect of an increase in the price of an inferior good (good X)on the quantity of that good that is consumed

Inferior Good

SE:

IE:

TPE:

IE SE

QP

Q RI P

QP




The effect of an increase in the price of the Giffen good on the

quantity of that good that is consumed

Giffen Good

SE:

IE:

TPE:

SE IE

QP

Q RI P

QP



The Difference between Individual and MarketDemand

Individual demand refers to the amount of the good that isdemanded by one person at different prices.

The Market Demand refers to the total amount of the goodthat is demanded by all the buyers at different prices.

We can get the Market Demand by summing all theindividual demands at the different prices.



Summary

For this Unit we have looked at:

Factors determining Market Demand.

Price Elasticity of Demand, Income Elasticity of Demandand Cross-Price Elasticity of Demand.

The Theory of the Consumer – Budget Constraint, BudgetLine, Indifference Curve, Consumer Equilibrium.

Price and Income Consumption Curves.

The Decomposition of the Total Price Effect (TPE) in to theIncome and Substitution Effects.

The difference between individual and market demand.

econ notes 1

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