Individual and Market Demand

Mir Ahasan Kabir, Ph.D.

Department of Economics
University of Toronto
[email protected]

October 17, 2024

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Chapter 5 Outline

5.1 How Income Changes Affect an Individual’s Consumption Choices

5.2 How Price Changes Affect Consumption Choices
5.3 Consumer Responses to Price Changes: Substitution and Income
Effects
5.4 The Impact of Changes in Another Good’s Price: Substitutes and
Complements
5.5 Combining Individual Demand Curves to Obtain the Market Demand
Curve
5.6 Conclusion

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Introduction

With the consumer choice framework in place, we now link consumer

decisions with individual and market demand.

These links help determine:

why shifts in tastes affect prices.
the benefits products offer consumers.
what happens to purchase patterns as consumers (or even entire
countries) become wealthier.
how changes in the price of one good affect the demand for other
goods.
what factors determine consumers’ responses to price changes.

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Budget Constraint

The individual’s budget constraint is:

PX X + PY Y = I

Where:
PX and PY are the prices of goods X and Y .
I is the individual’s income.
X and Y are the quantities of goods consumed.
A change in income shifts the budget constraint
  outward (higher income)
PX
or inward (lower income), but the slope − PY remains unchanged.

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Utility Maximization Problem

The consumer maximizes utility:

U(X , Y ) = f (X , Y )

subject to the budget constraint:

PX X + PY Y = I

The solution to the utility maximization problem yields the optimal bundle
(X ∗ , Y ∗ ), where the marginal rate of substitution (MRS) equals the price
ratio:
MUX PX
=
MUY PY

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5.1 How Income Changes Affect Consumption Choices

Income Effect: The change in a consumer’s consumption choices due to

a change in income, holding relative prices constant.
Normal Goods: Higher income leads to higher consumption.
Inferior Goods: Higher income leads to lower consumption.

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5.1 How Income Changes Affect Consumption Choices

Income Elasticity of Demand:

∆Q I
E= ·
Q ∆I
Where:
E > 0 for normal goods,
E < 0 for inferior goods.

∆Q
The income effect is given by ∆I

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5.1 How Income Changes Affect Consumption Choices

There are two additional sub-types of goods that are common, both of
these are classified as normal goods because, as income increases, the
quantity demanded for them increases as well, and vice versa.

Types of Normal Goods:

Necessity Goods: 0 < E < 1
Examples for Necessity goods: water consumption, electricity,
clothing, etc. . .
Luxury Goods: E > 1
Examples for Luxury goods: vacation homes, jewelry, expensive
steaks, etc. . .

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5.1 How Income Changes Affect Consumption Choices

Figure 5.1 A Consumer’s Response to an Increase in Income When

Both Goods Are Normal

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5.1 How Income Changes Affect Consumption Choices
Alternatively, for inferior goods, higher income is associated with falling
consumption.

Figure 5.2 Consumer’s Response to an Increase in Income When

One Good is Inferior

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Question 1

If the consumption of fresh cut flowers increases by 10% when consumers’

incomes increase by 5%, fresh cut flowers are:
a inferior goods.
b necessity goods.
c luxury goods.
d ordinary goods.

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Question 1

If the consumption of fresh cut flowers increases by 10% when consumers’

incomes increase by 5%, fresh cut flowers are:
a inferior goods.
b necessity goods.
c luxury goods.
d ordinary goods.

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Income Expansion Path
The income expansion path connects a consumer’s optimal bundles at
different income levels.
Positive slope indicates both goods are normal.
Negative slope indicates one good is inferior.

Figure 5.3 The Income Expansion Path

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Engel Curves

An Engel curve plots the relationship between income and the

quantity of a good consumed.
For normal goods, the Engel curve is upward sloping.
For inferior goods, the Engel curve is downward sloping.
Example:
X = 0.5I
Where X is the quantity of a good and I is the income.

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Engel Curve
Engel Curve: Shows the relationship between quantity consumed and
income.
Positive slope: normal good.
Negative slope: inferior good.

Figure 5.4 An Engel Curve Shows How Consumption Varies with

Income
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Question 2

Susan’s income elasticity for canned meat is negative at each of her

income levels and is positive for organic fruit. This implies that Susan’s
income expansion path along her optimal canned meat and organic fruit
bundles will have a slope, and the Engel curve for canned meat will
have a slope.
a positive; positive
b positive; negative
c negative; positive
d negative; negative

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Question 2

Susan’s income elasticity for canned meat is negative at each of her

income levels and is positive for organic fruit. This implies that Susan’s
income expansion path along her optimal canned meat and organic fruit
bundles will have a slope, and the Engel curve for canned meat will
have a slope.
a positive; positive
b positive; negative
c negative; positive
d negative; negative

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5.2 How Price Changes Affect Consumption Choices

Just as income affects consumer choices, changes in relative prices —

holding income constant — also affects these choices.

Deriving a Demand Curve

Demand curves define a relationship between quantity demanded and
price.
To derive a demand curve, we must understand how a consumer
responds to a change in price.
By changing one price on an indifference curve—budget constraint
map, we can observe changes to consumer choices and then build the
demand curve for an individual using these observed changes.
The observed price represents the maximum willingness to pay for the
last unit consumed.

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5.2 How Price Changes Affect Consumption Choices

Budget Constraint Rotations

When PX changes, the budget line pivots around the Y -intercept.
New budget constraint:

PX′ X + PY Y = I
P′
Slope changes to − PYX .

When relative prices change, holding income constant, consumers adjust

their consumption choices.

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5.2 How Price Changes Affect Consumption Choices
Deriving Demand Curves:
Changes in price are analyzed using indifference curves and budget
constraints.

Figure 5.5 Building an Individual’s Demand Curve

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Shifts in the Demand Curve

Demand curves shift due to changes in consumer preferences, income, or

prices of other goods.

Example: If consumer preferences shift from grape juice to Mountain

Dew:
Consumption of grape juice decreases,
Demand curve for grape juice shifts inward.

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Shifts in the Demand Curve

(a) Caroline’s indifference curves for

grape juice flatten when her
preference for grape juice decreases
relative to her preference for
Mountain Dew. At each price level,
she now consumes fewer bottles of
grape juice.

(b) Because she purchases fewer

bottles of grape juice at each price
point, Caroline’s demand curve for
Figure 5.6 Preference grape juice shifts inward from D1 to
Changes and Shifts in the D2.
Demand Curve

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5.3 Substitution and Income Effects

When the price of a good changes relative to another, two things happen:
1 One good becomes relatively more expensive, and the other relatively
less.
2 The total purchasing power of a consumer’s income changes.

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5.3 Substitution and Income Effects

1 The substitution effect refers to the change in a consumer’s

consumption choices that results from a change in the relative prices
of two goods. When the price of one good relative to another
increases, consumption of the former falls, and vice versa, Always
negative.
2 The income effect refers to the change in a consumer’s consumption
choices that results from a change in the purchasing power of the
consumer’s income. Can be negative or positive (inferior or normal
goods).
The total effect of a change in a price is the sum of the substitution and
income effects. Total Effect:

∆QX = Substitution Effect + Income Effect

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5.3 Substitution and Income Effects

Figure 5.7 The Effects of a Fall in the Price of Basketball Tickets

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5.3 Substitution and Income Effects

Total Effect:

∆QX = Substitution Effect + Income Effect

Isolating the Substitution Effect

Determine the bundle of goods that would have been chosen at the new
price while maintaining utility experienced before the price change.

Isolating the Income Effect

The change in quantities demanded due to the changes in the consumer’s
purchasing power after the change in prices

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5.3 Substitution and Income Effects

Substitution Effect:
To do this for a fall in the price of basketball tickets, shift the new
budget constraint (BC2 ) inward until it is tangent with the old
indifference curve (BC ′ ).
Movement along the original indifference curve (A to A′ )
Income Effect:
When the price of basketball tickets decreases, the consumer can afford to
purchase a larger bundle than before.
Represented by the change in the quantity of goods consumed from
bundle A′ (after the substitution effect) to bundle B

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5.3 Substitution and Income Effects

Figure 5.8 Substitution Effects and Income Effects for Two Normal
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5.3 Substitution and Income Effects

Three steps to computing substitution and income effects associated with

a price change, starting with a consumer at an optimal bundle A:
1 Draw the new budget constraint and find the new optimal bundle (B).
A price change for one of two goods rotates or pivots the constraint.
2 Draw a line parallel to the new budget constraint, but tangent to the
old indifference curve; determine the optimal bundle on the old curve
associated with this theoretical budget constraint (A′ ).
3 The substitution effect is the difference in quantities between A and
A′ and the income effect is the difference in quantities between A′
and B.

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5.3 Substitution and Income Effects

What Determines the Size of the Substitution and Income Effects?

Curvature: The size of the substitution effect depends on the
curvature of indifference curves.
- When an indifference curve is relatively straight - the 2 goods are
relatively substitutable.
Quantity consumed before the price change: The income effect
increases with the amount spent on a good before a price change.
- The income effect increase with the amount spent on a good -
because the more you can get from trading off consumption of that
good.

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5.3 Substitution and Income Effects

Figure 5.10 A Fall in the Price of an Inferior Good

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5.3 Substitution and Income Effects

1 Price of ramen noodles has

decreased
- Sub. Effect positive
2 Relative price of steak has increased
- Sub. Effect negative
3 Relative income has increased
- Income effect positive for steak
(normal good) and negative for
ramen (inferior good)
Figure 5.11 Substitution and The income effect dominates the
Income Effects for an Inferior substitution effect for steak.
Good The substitution effect dominates the
income effect for ramen noodles.

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5.3 Substitution and Income Effects

Giffen goods: goods for which a fall in price leads the consumer to want
less of the good
An extreme case where the good is inferior and the income effect
outweighs the substitution effect.
When the price of a Giffen good drops, the substitution effect (which
acts to increase demand) is smaller than the income effect.
- Results in an upward sloping demand curve!

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5.3 Substitution and Income Effects

Figure 5.12 A Change in the Price of a Giffen Good

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5.3 Substitution and Income Effects
Income Effects
Involve comparisons of bundles that lie on
two different indifference curves.
The direction of the effect on quantity
Substitution Effects consumed for a given change in the
relative price of the good is ambiguous
Involve comparisons of bundles that line and depends on whether the good is
on the same indifference curve. normal or inferior.
The direction of the effect on quantity If the good is normal, then a fall in either
consumed for a given change in the its price or the price of the other good
relative price of the good is unambiguous. will cause the consumer to want more of
If the good’s relative price falls, the it. (A drop in any price, even of another
substitution effect causes the consumer to good, increases the effective income of
want more of it. the consumer.) If the good is inferior,
If the good’s relative price rises, the then a price drop will cause the consumer
substitution effect causes the consumer to to want less of it.
want less of it. If the good is normal, then a rise in it’s
price or the price of the other good will
cause the consumer to want less of it. If
the good is inferior, then a rise in either
price will cause the consumer to want
more of it.
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Question 3

At his current income level, Randall’s income elasticity for frozen dinners is
-0.75. If the price of frozen dinners decreases by 10%, the substitution
effect will cause Randall to his consumption of frozen dinners, and
the income effect will cause Randall to his consumption of frozen
dinners.
a increase; increase
b increase; decrease
c decrease; increase
d decrease; decrease

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Question 3

At his current income level, Randall’s income elasticity for frozen dinners is
-0.75. If the price of frozen dinners decreases by 10%, the substitution
effect will cause Randall to his consumption of frozen dinners, and
the income effect will cause Randall to his consumption of frozen
dinners.
a increase; increase
b increase; decrease
c decrease; increase
d decrease; decrease

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Slutsky Equation

The Slutsky equation shows the decomposition of the total effect of a

price change into substitution and income effects:

∂X ∗
 
∂X ∂X ∂I
= + ×
∂PX ∂PX ∂I ∂PX

Where X ∗ is the substitution effect and the second term represents

the income effect.
Substitution effect is always negative for a price increase, while the
income effect depends on whether the good is normal or inferior.

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5.4 The Impact of Changes in Another Good’s Price:
Substitutes and Complements

How a change in the price of one good affects the demand for another.
Cross price elasticity:
∂QX PY
EXY = ×
∂PY QX
EXY > 0: Goods X and Y are substitutes.
EXY < 0: Goods X and Y are complements.

Example
Substitutes: Tea and coffee, butter and margarine.
Complements: Left shoes and right shoes, cars and gasoline.

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Cross-Price Elasticity Example

Consider two goods, X and Y :

QX = 100 − 2PX + 3PY

If the price of good Y increases, the demand for X increases,

indicating that they are substitutes.
The cross-price elasticity can be calculated as:
3 × PY
EXY =
QX

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5.4 The Impact of Changes in Another Good’s Price:
Substitutes and Complements

At original prices, this consumer

purchases 15 bottles of Pepsi
and 5 bottles of Coke.
When the price of Pepsi
doubles, Coke consumption
increases by 100% (to 10
bottles), and Pepsi consumption
falls by 67% (to 5 bottles).
Coke consumption rose when
Figure 5.13 When the Price of a
the price of Pepsi rose, signifying
Substitute Rises, Demand Rises
that they are substitutes.

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5.4 The Impact of Changes in Another Good’s Price:
Substitutes and Complements

At original prices, this consumer

purchases 20 tubs of ice cream
and 30 jars of hot fudge.
When the price of ice cream
doubles, consumption of ice
cream falls by 25% (20 to 15
tubs), and consumption of hot
fudge decreases by 33% (30 to
20 jars).
Figure 5.14 When the Price of a Hot fudge consumption
Complement Rises, Demand decreased when the price of ice
Decreases cream increased, signifying that
they are complements.
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5.4 The Impact of Changes in Another Good’s Price:
Substitutes and Complements
A Change in the Price of Substitutes and Complements help to explain the
shifts in demand examined in Chapter 2.

Figure 5.15 Changes in the Prices of Substitutes or Complements

Shift the Demand Curve

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5.5 Combining Individual Demand Curves to Obtain the
Market Demand Curve
Linking consumer theory to market demand:
Market demand is the horizontal sum of individual demand curves.
The market quantity demanded at each price is the sum of the individual
quantities demanded at each price.
N
X
QMarket (P) = Qi (P)
i=1

Figure 5.17 The Market Demand Curve

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Market Demand Example

Suppose two consumers have demand curves:

Q1 = 50 − 2P, Q2 = 40 − P

The market demand curve is:

Qmarket = (50 − 2P) + (40 − P) = 90 − 3P when p ≤ 25

Qmarket = 40 − P when p > 25

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Factors Influencing Market Demand

Number of consumers in the market.

Distribution of income among consumers.
Tastes and preferences.
Prices of related goods.

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Question 1: Malachi’s Consumption Choices

Malachi consumes two goods: DVD rentals (R) and coffee (C). His utility
function is:
U(R, C ) = R 0.75 C 0.25

A Malachi has $16 to spend, with the prices of rentals at $4 and coffee
at $2 per cup. Solve for the optimal bundle.
B Malachi signs up for a membership that reduces the price of rentals to
$2. Solve for the substitution effect and income effect.
C From your answer to part (b), are DVD rentals and coffee normal or
inferior goods for Malachi? Explain.

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Question 2 (Part A): Solving for the Optimal Bundle
Utility Maximization Problem:

max R 0.75 C 0.25 s.t. 16 = 4R + 2C

Lagrangian:

L(R, C , λ) = R 0.75 C 0.25 + λ(16 − 4R − 2C )

First-Order Conditions:
∂L
= 0.75R −0.25 C 0.25 − 4λ = 0
∂R
∂L
= 0.25R 0.75 C −0.75 − 2λ = 0
∂C
∂L
= 16 − 4R − 2C = 0
∂λ
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Question 2 (Part A): Solving for the Optimal Bundle

Solve for R as a function of C using the first two constraints:

0.25 ∗ 0.75R −0.25 C 0.25 = 0.5 ∗ 0.25R 0.75 C −0.75

R = 1.5C
Plug into the budget constraint:

16 − 4R − 2C = 0 =⇒ 6C + 2C = 16

C ∗ = 2, R ∗ = 3

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Question 1 (Part B): Substitution and Income Effects

To find the substitution effect, solve Malachi’s expenditure - minimization

problem using the lower price of rentals with his original utility as the
constraint. Malachi’s original utility is

Ū = 30.75 20.25 ≈ 2.71

Expenditure Minimization Problem:

min 2R + 2C s.t. U = 2.71 where U = R 0.75 C 0.25

Lagrangian:

L(R, C , λ) = 2R + 2C + λ(2.71 − R 0.75 C 0.25 )

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Question 1 (Part B): Substitution and Income Effects
First-Order Conditions:
∂L
= 2 − λ0.75R −0.25 C 0.25 = 0
∂R
∂L
= 2 − λ0.25R 0.75 C −0.75 = 0
∂C
Solving for R(C):
0.75R −0.25 C 0.25 = 0.25R 0.75 C −0.75
R = 3C
Plug into the utility constraint:
2.71 = (3C )0.75 C 0.25 =⇒ 2.71 = 30.75 C
Solve for C:
C ∗ = 1.2, R ∗ = 3.6
The substitution effect increases rental consumption by 0.6 units and
reduces coffee consumption by 0.8 units.
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Question 1 (Part B): Substitution and Income Effects

Therefore, the substitution effect of the decrease in the price of rentals is

to consume 0.6 more rentals (3.6-3=0.6) and 0.8 fewer cups of coffee
(2-1.2=-0.8).
To get the income effect, we need to find the optimal bundle at the new
price of rentals and the original income.

Utility Maximization Problem:

max R 0.75 C 0.25 s.t. 16 = 2R + 2C

Lagrangian:

L(R, C , λ) = R 0.75 C 0.25 + λ(16 − 2R − 2C )

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Question 1 (Part B): Substitution and Income Effects
First-Order Conditions:
∂L
= 0.75R −0.25 C 0.25 − 2λ = 0
∂R
∂L
= 0.25R 0.75 C −0.75 − 2λ = 0
∂C
∂L
= 16 − 2R − 2C = 0
∂λ
R = 3C
16 = 2R + 2C =⇒ 16 = 6C + 2C =⇒ C ∗ = 2; R ∗ = 6
So, the income effect of the decrease in the price of rentals is to consume
2.4 more rentals (6-3.6=2.4) and 0.8 more cups of coffee (2-1.2=0.8).
The total effect is to consume 3 more rentals (6-3=3) and the same
number of coffees.
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Question 1 (Part C): Normal or Inferior Goods

Income Effect: Use the new prices and the original income:

R ∗ = 6, C∗ = 2

Conclusion: The income effect is positive for both rentals and coffee,
meaning both goods are normal.

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5.6 Conclusion

We have covered how changes in income and prices affect individual

and market demand.
Substitution and income effects play key roles in determining how
consumers respond to price changes.
Cross-price effects help explain how demand for one good responds to
changes in the price of another good.
Market demand curves are derived from the aggregation of individual
demand curves.

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 Questions ???
Comments !!!
Suggestions ...

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