• Price effect: change in optimal consumption of a good associated with a change in its price, holding income and other prices constant

$$\frac{\Delta q_x^D}{\Delta p_x}<0$$

The law of demand: as the price of a good rises, people will tend to buy less of that good (and vice versa)

• i.e. the price effect is negative!

• Suppose there is only 1 good to consume, $x$. You have a $100 income, and the price of $x$ is $10. You consume 10 units of $x$

• Suppose the price of $x$ rises to $20. You now consume 5 units of $x$.

• This is the real income effect

• Real income effect: your consumption mix changes because of the change in the price of $x$ changes your real income or purchasing power (the amount of goods you can buy)

• Note your actual (nominal) income ($100) never changed!

• The size of the income effect depends on how large a portion of your budget you spend on the good

• Large-budget items:

  • e.g. Housing/apartment rent, car prices
  • Price increase/decreases makes you much poorer/wealthier

• The size of the income effect depends on how large a portion of your budget you spend on the good

• Small-budget items:

  • e.g. pencils, toothpicks, candy
  • Price changes don’t have much of an effect on your wealth or change your behavior much

• Suppose there are 1000’s of goods, none of them a major part of your budget

  • So real income effect is insignificant

• Suppose the price of good $x$ increases

• You would consume less of $x$ relative to other goods because $x$ is now relatively more expensive

• That’s the substitution effect

• Substitution effect: consumption mix changes because of a change in relative prices

• Buy more of the (now) relatively cheaper items

• Buy less of the (now) relatively more expensive item $\left(x\right)$

• Original optimal consumption $\left(A\right)$

• Original optimal consumption $\left(A\right)$

• (Total) price effect: $A\to C$

• Let's decompose this into the two effects

• Substitution effect: what you would choose under the new exchange rate to remain indifferent as before the change

• Substitution effect: what you would choose under the new exchange rate to remain indifferent as before the change

• Graphically: shift new budget constraint inwards until tangent with old indifference curve

• $A\to B$ on same I.C. $(\text{udownarrow}$ $x$, $\uparrow$ $y)$

  • Note: Point B must be a different point on the original curve! Why?

• (Real) income effect: change in consumption due to the change in purchasing power from the change in price

• (Real) income effect: change in consumption due to the change in purchasing power from the change in price

• $B\to C$ to new budget constraint (can buy less of $x$ and/or $y$)

• Original optimal consumption $\left(A\right)$

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Substitution effect: $A\to B$ on same I.C. $(\downarrow$ more expensive $x$ and $\uparrow$ $y)$

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Substitution effect: $A\to B$ on same I.C. $(\downarrow$ more expensive $x$ and $\uparrow$ $y)$

• (Real) income effect: $B\to C$ to new budget constraint (can buy less of $x$ and/or $y$)

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Substitution effect: $A\to B$ on same I.C. $(\downarrow$ more expensive $x$ and $\uparrow$ $y)$

• (Real) income effect: $B\to C$ to new budget constraint (can buy less of $x$ and/or $y$)

• (Total) price effect: $A\to C$

• Original optimal consumption $\left(A\right)$

• Original optimal consumption $\left(A\right)$

• (Total) price effect: $A\to C$

• Let's decompose this into the two effects

• Substitution effect: what you would choose under the new exchange rate to remain indifferent as before the change

• Substitution effect: what you would choose under the new exchange rate to remain indifferent as before the change

• Graphically: shift new budget constraint inwards until tangent with old indifference curve

• $A\to B$ on same I.C. $(\downarrow$ $x$, $\uparrow$ $y)$

• (Real) income effect: change in consumption due to the change in purchasing power from the change in price

• (Real) income effect: change in consumption due to the change in purchasing power from the change in price

• $B\to C$ to new budget constraint (can buy less of $x$ and/or $y$)

• Original optimal consumption $\left(A\right)$

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Substitution effect: $A\to B$ on same I.C. $(\downarrow$ more expensive $x$ and $\uparrow$ $y)$

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Substitution effect: $A\to B$ on same I.C. $(\downarrow$ more expensive $x$ and $\uparrow$ $y)$

• (Real) income effect: $B\to C$ to new budget constraint (can buy less $x$ and/or $y$)

• Original optimal consumption $\left(A\right)$

• Price of $x$ rises, new optimal consumption at $\left(C\right)$

• Substitution effect: $A\to B$ on same I.C. $(\downarrow$ more expensive $x$ and $\uparrow$ $y)$

• (Real) income effect: $B\to C$ to new budget constraint (can buy less $x$ and/or $y$)

• (Total) price effect: $A\to C$

• Giffen good: theoretical good that violates law of demand

• Price increase (decrease) causes person to buy more (less)

• Note so far we have been talking about an individual person’s demand

• In principles, you learned about the entire market demand

• Note so far we have been talking about an individual person’s demand

• In principles, you learned about the entire market demand

• This is simply the sum of all individuals’ demands

• Demand schedule expresses the quantity of good a person(s) would be willing to buy $\left(q_D\right)$ at any given price $\left(p_x\right)$

  • Holding constant all other prices $\left(p_y\right)$ and income $\left(m\right)$! (“ceterus paribus”)

• Note: each of these is a consumer's optimum at a given price!

• Demand curve graphically represents the demand schedule

• Also measures a person's maximum willingness to pay (WTP) for a given quantity

• Law of Demand (price effect) $⟹$ demand curves always slope downwards

• Demand function relates quantity to price

• Not graphable (wrong axes)!

• Inverse demand function relates price to quantity
  • Take demand function and solve for $p$

• Graphable (price on vertical axis)!

• Inverse demand function relates price to quantity
  • Take demand function and solve for $p$

• Vertical intercept ("Choke price"): price where $q_D=0$ ($10), just high enough to discourage any purchases

• Read two ways:

• Horizontally: at any given price, how many units person wants to buy

• Vertically: at any given quantity, the maximum willingness to pay (WTP) for that quantity

  • This way will be very useful later

• Note a simple (inverse) demand function only relates (own) price and quantity

• What about all the other "determinants of demand" like income and other prices?

• They are captured in the vertical intercept (choke price)!

• A change in one of the "determinants of demand" will shift demand curve!

  1. Change in income $m$
  2. Change in price of other goods $p_y$
  3. Change in preferences or expectations about good $x$

• Shows up in (inverse) demand function by a change in intercept (choke price)!

• See my Visualizing Demand Shifters