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Chapter 4

Chapter 4 discusses how demand changes in response to price fluctuations, highlighting the substitution and income effects. The Price-Consumption Curve and Individual Demand Curve illustrate how utility-maximizing combinations of goods vary with price changes, while the Engel Curve shows the relationship between consumption and income. The chapter concludes that the nature of goods (normal vs. inferior) affects how demand responds to price and income changes.

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4 views

Chapter 4

Chapter 4 discusses how demand changes in response to price fluctuations, highlighting the substitution and income effects. The Price-Consumption Curve and Individual Demand Curve illustrate how utility-maximizing combinations of goods vary with price changes, while the Engel Curve shows the relationship between consumption and income. The chapter concludes that the nature of goods (normal vs. inferior) affects how demand responds to price and income changes.

Uploaded by

ignacio.valdes0029
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© © All Rights Reserved
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Chapter 4: Demand Decisions

Demand and Price Changes


Objective: To find out how the effect on individual demand when prices change.
When a price increases, demand can vary in two ways:
1. Since the good is now more expensive in relation to other goods, the consumer
buys less of this good and more of the other goods.
2. Now the purchasing power of the consumer is smaller (exactly as a decrease in
income) and generates a decrease in the consumer’s demand.

Price-Consumption Curve: Traces the utility-maximizing combinations of two goods as


the price of one changes.
Individual Demand Curve: Relates the quantity of a good to its price for a single
consumer. It has two important properties:
1. The level of utility that can be attained changes as we move along the curve.
2. At every point on the demand curve, the consumer is maximizing utility by
satisfying the condition that the MRS is equal to the price ratio.
Types of goods given changes in price
ANOTHER EXAMPLE

Income-Consumption Curve: Traces the utility-maximizing combinations of two goods


as a consumer’s income changes.
Engel Curve: Relates the quantity of a good consumed to income.
Type of goods given changes in income:

Substitution and Income Effects


Substitution Effect: It is how the demand changes when prices change and purchasing
power is held constant, in the sense that the original bundle remains affordable. It is
negative as it always moves opposite to the price movement.
Income Effect: It is how the demand changes when the purchasing power changes. It
can be positive or negative as it can move either opposite or in the same direction to
the price movement. It will depend on whether the good is normal or inferior.
Slutsky equation says that the total change in demand is the sum of the substitution
effect and the income effect.
❑ s n
∆ x 1 =∆ x1 + ∆ x1
Total Change in demand Substitution effect Income effect

For normal goods both the substitution and the income effect work in the SAME
DIRECTION.
For inferior goods, both the substitution and the income effect work in opposite
directions. The final sign for the change in demand will depend how inferior the good
is.
CONCLUSION: A giffen good must be an inferior good, but an inferior

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