Individual and Market Demand Chapter 4 Chapter Outline Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Individual Demand Effect of Price Changes A reduction in the price of food with income and the price of clothing fixed causes this consumer to choose a different market basket In a the baskets that maximize utility for various prices of food point A 2 B 1 D 0 50 trace out the price consumption curve Part b gives the demand curve which relates the price of food to the quantity demanded Points E G and H correspond to points A B and D respectively Individual Demand Effect of Income Changes An increase in income with the prices of all goods fixed causes consumers to alter their choice of market baskets In part a the baskets that maximize consumer satisfaction for various incomes point A 10 B 20 D 30 trace out the incomeconsumption curve The shift to the right of the demand curve in response to the increases in income is shown in part b Points E G and H correspond to points A B and D respectively Normal versus Inferior Goods An increase in a person s income can lead to less consumption of one of the two goods being purchased Here hamburger though a normal good between A and B becomes an inferior good when the income consumption curve bends backward between B and C Engel Curves Engel curves relate the quantity of a good consumed to income In a food is a normal good and the Engel curve is upward sloping In b however hamburger is a normal good for income less than 20 per month and an inferior good for income greater than 20 per month Consumer Expenditures in the United States Engel Curves for U S Consumers Average per household expenditures on rented dwellings health care and entertainment are plotted as functions of annual income Health care and entertainment are normal goods as expenditures increase with income Rental housing however is an inferior good for incomes above 35 000 Income and Substitution Effects Substitution effect that component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods Income effect that component of the total effect of a price change that results from the associated change in real purchasing power Total effect the sum of the substitution and income effects Income and Substitution Effects Normal Good decrease in price of food The substitution effect F1E associated with a move from A to D changes the relative prices of food and clothing but keeps real income satisfaction constant The income effect EF2 associated with a move from D to B keeps relative prices constant but increases purchasing power Food is a normal good because the income effect EF2 is positive Income and Substitution Effects Inferior Good decrease in price of food The resulting change in food purchased can be broken down into a substitution effect F1E associated with a move from A to D and an income effect EF2 associated with a move from D to B In this case food is an inferior good because the income effect is negative However because the substitution effect exceeds the income effect the decrease in the price of food leads to an increase in the quantity of food demanded Giffen Goods Giffen good one for which the quantity demanded rises as its price rises The Giffen good must be an inferior good Income effect must dominate substitution effect The good must occupy a large share of the consumer s budget increase in its price should make consumer significantly poorer Example Irish potato famine of 19th century Income and Substitution Effects Upward Sloping Demand Curve The Giffen Good The consumer is initially at point A but after the price of food falls moves to B and consumes less food Because the income effect EF2 is larger than the substitution effect F1E the decrease in the price of food leads to a lower quantity of food demanded