Slide 1Econ 410: Micro TheoryUnderstanding Individual DemandFriday, September 14th, 2007Slide 2The plan for today… Writing Assignment Details Individual Demand and Income How can we describe normal and inferior goods more formally? Characterizing the effects of a price change What are the income and substitution effects? How do they contribute to individual demand changes in response to price?Slide 3Recall from last time… As the price of a product changes, we can observe a consumer’s optimal consumption bundles to derive the individual demand curve At all points along this curve: The maximum attainable level of utility changes It is always true thatyXyxMUMUPPQuantityPriceCAB$2.004 12 20$1.00$.50Slide 4Income & Individual Demand We now know that we can relate consumer optimization to individual demand through price changes. Substitutes and Complements We can use the same techniques to model a change in income Question If prices remain fixed, what is the effect of a change in income on the optimal market basket? How can we relate these changes to the individual’s demand curve for a good?Slide 5Income & Individual DemandVideogamesCheesy-Poofs•As income increases, consumers change their optimal market basket to reflect their newfound wealth.•The utility-maximizing choice must be on the new budget constraint and tangent to the highest indifference curve possible34AU1510BU2C716U3Slide 6Income & Individual Demand The Income-Consumption curveshows the utility-maximizing market basket at each income levelVideogamesCheesy-Poofs32AU155BU2C78U3Income-Consumption CurveSlide 7Income & Individual Demand As the budget constraint shifts outward: The quantity consumed of the good increases (usually!) The individual demand shifts rightwardBQuantityPrice of Videogames$10.002D1A5D28D3CSlide 8Normal vs. Inferior Goods If a consumer buys more of a good as their income increases, that good is classified as normal Positive income elasticity of demand The slope of the income-consumption curve is positive If a consumer buys less of a good as their income increases, that good is classified as inferior The slope of the income-consumption curve is negative Example: Dog FoodSlide 9Normal vs. Inferior GoodsDog Food (Cans)LobsterTails105AU12204BU230U3C…but dog food becomes an inferior good when the income consumption curve bends backward between B and C.Both dog food and lobster behave as a normal good, between A and B...But….What happens if the consumer’s income increases enough for him to buy a dog?Slide 10Engel Curves Engel Curves depict the relationship between the quantity consumed of a good and a consumer’s income These curves can be directly derived from the Income-Consumption curveSlide 11Engel CurvesNormal GoodNormal GoodInferior GoodSlide 12Income & Substitution Effects As discussed last class, a change in the price of a good has two competing effects When the price of a good falls and it becomes cheaper relative to other goods, people tend to buy more of it This is known as the Substitution Effect But…because the good is cheaper, people can buy the same amount for less money, and have more cash to spend on other things This is known as the Income EffectSlide 13Example Lauren visits Lenoir every day for lunch, and gets a Chick-Fil-A sandwich for $3.00 and a Diet Coke One day, she walks in, and the price of a Chick-Fil-A sandwich has risen to $1,000 But, Lauren’s long-lost uncle shows up and at Lenoir and gives her $1,000  Do you think she’ll buy the sandwich? Real income has been held constant, and only relative prices have changed.Slide 14Modeling the Effects Formally, the 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 When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the goodSlide 15The Substitution EffectLobsterOSteakL1S1AU1L2SubstitutionEffectBThe substitution effect,(from point A to B), changesrelative prices but keeps real income (satisfaction) constant.Budget Line #1Budget Line RotatesUtility Remains ConstantSlide 16The Income Effect The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant When a person’s 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 effectSlide 17The Income EffectLobsterOSteakL1S1AU1The income effect, (from B to C) keeps relative prices constant but increases purchasing power.Income EffectS2L3U2CBBudget Line ShiftsSlide 18Putting the Effects TogetherLobsterOSteakL1S1AU1Income EffectS2L3U2CL2Total EffectSubstitutionEffectBThe income effect, L2L3, (from B to C) keeps relativeprices constant but increases purchasing power.When the price of lobster falls, consumption increases by L1L3as the consumer moves from A to C.The substitution effect, L1L2, (from point A to B), changes the relative prices but keeps real income(satisfaction) constant.Slide 19For next time… Make sure you have read sections 4.2 and 4.3 of your textbook Problem Set Reminder Due September 21st Chapter 3 Problems Questions for Review, #6, #12 Exercises, #5, #7, #10, #15 Chapter 4 Problems (Appendix) #2, #4, #5 Problems from Chapter 4 will be worth 2 points each, while problems from Chapter 3 will be worth 1 point