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Ch. 5: Applying Consumer Theory Guidelines Part 1: Exp. Onx

This chapter discusses key concepts in consumer theory, including: 1. Price-consumption curves show the relationship between the price of a commodity and the quantity consumed as the consumer reaches maximum utility. They can take different shapes depending on the price elasticity of demand. 2. Income-consumption curves show the relationship between income and consumption levels as maximum utility is reached. Their shape depends on income elasticities of demand for goods. 3. The decomposition of total effect examines how a price change affects expenditure on a good through substitution and income effects. It demonstrates the relationship between price, quantity demanded, and total revenue.

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53 views3 pages

Ch. 5: Applying Consumer Theory Guidelines Part 1: Exp. Onx

This chapter discusses key concepts in consumer theory, including: 1. Price-consumption curves show the relationship between the price of a commodity and the quantity consumed as the consumer reaches maximum utility. They can take different shapes depending on the price elasticity of demand. 2. Income-consumption curves show the relationship between income and consumption levels as maximum utility is reached. Their shape depends on income elasticities of demand for goods. 3. The decomposition of total effect examines how a price change affects expenditure on a good through substitution and income effects. It demonstrates the relationship between price, quantity demanded, and total revenue.

Uploaded by

KARIM
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Ch.

5: Applying Consumer Theory Guidelines Part 1


This chapter is a continuation to chapter 4 about utility maximization. It starts with (1) price-
consumption (PC) curves and (2) income-consumption (IC) curves. Then it continues to the
important (3) decomposition of total effect into substitution and income effect. And ends in
topics such as (4) derivation of supply of labor, the Laffer curve, and lump-sum tax vs unit tax.
Price-Consumption curves: This is an easy part; it shows the locus of tangencies between
budget lines and ic’s at utility maximization when P of a commodity varies. Hence, the name
price-consumption curve. The PC curve could take many shapes: vertical, horizontal, downward
sloping, upward sloping, …
Y

A
Exp. PC

On X
e2 ic2 D
e1 ic1
Exp.

On
0 B
Other B’ I/Px
I/Px’ X
goods
The PC in the above diagram is the usual case. There are exceptions of course. The PC
above starts at point A on the vertical axis and has the shape of a parabola that is open
from above (or the mirror image of a parabola that opens from below or a dome).Can
you figure out why?
The above diagram shoes the locus of tangencies between budget lines such as AB and
AB’ and ic’s such as ic1 and ic2 when Px varies. Actually, we could draw an infinite
number of budget lines tangent to an infinite number of ic’s as we decrease Px. The
locus of these tangencies at maximization of utility is the PC.
Note that in the above diagram and in many coming diagrams later, the variable on the
vertical axis (commodity Y) could be replaced by the expenditure on commodity X which
is Px.X measured from point A downwards. And consequently, we could measure the
expenditure on other goods on the vertical axis measured from 0 upwards.0Y therefore
will be income or real income decomposed into expenditure on X and expenditure on
other goods. This decomposition is very useful as we see later.
So, for example, if the consumer is maximizing utility at point e1 on ic1 on budget line
AB, then the vertical distance AD is the (expenditure on X) = Px.X, and the vertical
distance OD is the expenditure on other goods. Could you figure out what happens to
the expenditure on X if the consumer moves to e2 on ic2 on budget line AB’? This
movement is caused by a decrease in Px to Px’ and the budget line rotates outwards.
Notice that point D’ (not drawn) will now be above point D on the vertical axis. This
means that when PC is upward sloping, expenditures on X will decrease because AD’ is
smaller than AD. So, Px.X will decrease when Px decreases. But what is Px.X? Does it
have another name? Yes, it is TR: total revenue. Now we have a relation between Px and
TR. So, could you now answer the question I asked before about the usual shape of PC
as to why it is a parabola that opens from above? Answer: it is a mirror image to TR.
Since TR is dome-shaped, PC is its mirror image. The relation between Px and Px.X is
defined by the elasticity of demand.
Lesson: when PC is downward sloping, TR is upward sloping. A decrease in Px will
increase TR (Px.X) on the vertical axis or the distance AD when demand is elastic. Px and
TR (Px.X) move in opposite directions. And vice versa. When PC is upward sloping, TR is
downward sloping. A decrease in Px will decrease TR (Px.X) on the vertical axis or the
distance AD when demand is inelastic. Px and TR (Px.X) move in the same direction.

TR

[Px.X] X

PC

Income-Consumption (IC) curves: Just as the PC was a locus of tangencies between


budget lines and ic’s when Px varies, the IC is a locus of these tangencies when income
varies. And just as the shape of PC depends on the price elasticity of demand, the IC
depends on the income elasticity of demand. So, it could also take different shapes:
upward sloping, downward sloping, horizontal, vertical, …But the IC now depends on
the income elasticities of both commodities Y and X. Because income affects both Y and
X. The PC however, is a result of a change in Px alone, so its shape only depends on the
price elasticity of Dx alone.
Study the above diagram, it is very easy. The IC depends on the income elasticities of
both goods Y and X. If we want to focus on one commodity alone, we draw the Engel
curve (below).

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