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Lecture5 PDF

This document provides an overview of demand theory, including individual demand curves, substitute and complementary goods, normal and inferior goods, and the income and substitution effects. It discusses how to derive demand curves analytically by solving utility maximization problems. Key definitions are provided for Engel curves, normal and inferior goods, and the substitution effect. The document explains how to calculate aggregate demand by horizontally summing individual demands. It introduces the concepts of positive and negative network externalities like the bandwagon and snob effects.

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Saurabh Sharma
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28 views

Lecture5 PDF

This document provides an overview of demand theory, including individual demand curves, substitute and complementary goods, normal and inferior goods, and the income and substitution effects. It discusses how to derive demand curves analytically by solving utility maximization problems. Key definitions are provided for Engel curves, normal and inferior goods, and the substitution effect. The document explains how to calculate aggregate demand by horizontally summing individual demands. It introduces the concepts of positive and negative network externalities like the bandwagon and snob effects.

Uploaded by

Saurabh Sharma
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Managerial  

Economics
MBAFT 6103

1
Today
Theory of Demand

2
Overview

1.  Individual Demand Curves

2.  Substitute Goods/ Complementary Goods

3.  Normal Goods/Inferior Goods

4.  Income Effect and Substitution Effect

5. Constructing Aggregate Demand

3
Individual Demand Curves

Where do they come from?
An individual’s demand curve for good X is derived
by varying Px (and holding everything else constant)
and plotting each new optimal value of X (obtained
by applying the optimal choice rule) against the
corresponding Px. The demand curve is also a
“willingness to pay curve”.

4
Individual  Demand  Curve  for  X

For  each  value  of  Px  calculate  consumer  demand  for  good  x  by  solving  the  
consumer’s  utility  maximization  problem,  holding  Py  and  income  constant.  Plot.

PX

PX = 4 •
PX = 2 • U increasing
PX = 1 •
XA XB XC X
Individual  Demand  Curves  

Key  Points
•  The consumer is maximizing utility at every point
along the demand curve

•  The marginal rate of substitution falls along the


demand curve as the price of x falls (if there was an
interior solution).

•  As the price of x falls, utility increases along the


demand curve.

6
Demand  Curve  for  good  x
How  to  derive  analytically
•  Algebraically, solve for the individual’s demand
using the following equations:

1. pxx + pyy = I
2.  MUx/px = MUy/py – at a tangency.

•  Find out the relationship between Px and x which


will give the demand curve for x for constant
value of y and I. Similarly the relation between Py
and y will give the demand curve for y.

(If the second equation does not hold, then check


the corner points where either x = 0 or y = 0.)
Some  Definitions
Substitute Goods
An increase in the price of good X leads to an
increase in the consumption of good Y and
vice versa. Examples:
•  Coke and Pepsi.
•  Wheat and Barley.

Complementary Goods
An increase in the price of good X leads to a
decrease in the consumption of good Y.
Examples:
•  DVDs and DVD players.
•  Computer CPUs and monitors.
•  Barley and Poultry.
Income  Consumption  Curve
Definition: The income consumption curve is
the set of optimal baskets for every possible
level of income, holding all the prices
constant.
Engel  Curve

The income consumption curve for good x also


can be written as the quantity consumed of good
x for any income level. This is the individual’s
Engel Curve for good x. When the income
consumption curve is positively sloped, the slope
of the Engel Curve is positive.
Engel  Curve
I ($)

Engel Curve
X is a normal good
92

68

40

0 10 18 24 X (units)
Some  More  Definitions
Normal Good
•  If the consumer purchases more of good x as her
income rises, good x is a normal good.
• Equivalently, if the slope of the Engel curve is
positive, the good is a normal good.

Inferior Good
• If the consumer purchases less of good x as her
income rises, good x is an inferior good.
• Equivalently, if the slope of the Engel curve is
negative, the good is an inferior good.
Price  and  Demand:
What  is  the  connection?

As the price of x falls, all else constant,


purchasing power rises. This is called the income
effect of a change in price.

The income effect may be positive (normal


good) or negative (inferior good).
Substitution  Effect
•  As the price of x falls, all else constant,
good x becomes cheaper relative to good y.
This change in relative prices alone causes
the consumer to adjust his/ her consumption
basket. This effect is called the substitution
effect.
•  The substitution effect always is negative.
•  Usually, a move along a demand curve will
be composed of both effects.
Income  and  Substitution  Effects  
Example  1:  Price  falls  from  PX1  to  PX2
Income  and  Substitution  Effects  
Example  2:  Price  falls  from  PX1  to  PX2
Aggregate  Demand

The market, or aggregate, demand function is


the horizontal sum of the individual (or
segment) demands.

In other words, market demand is obtained by


adding the quantities demanded by the
individuals (or segments) at each price and
plotting this total quantity for all possible
prices.
Calculating  Aggregate  Demand
Eg:  Two  Consumers  with  Different  Demands

P P

Q = 10 - p
Q = 20 - 5p

Q
Q
Segment 1 Segment 2

Calculate aggregate demand function in this market


Calculating  Aggregate  Demand
Example:  Two  Consumers  with  Different  Demands

P P P

10
Q = 10 - p Q = 20 - 5p
4

Q Q Q
Segment 1 Segment 2 Aggregate demand
   An  Important  Concept
     Network  Externality
If one consumer's demand for a good changes
with the number of other consumers who buy
the good, there are network externalities.

If one person's demand increases with the


number of other consumers, then the
externality is positive.

If one person's demand decreases with the


number of other consumers, then the
externality is negative.

Examples: ?
Positive  Network  Externality
               (Bandwagon  Effect)
PX D30: if consumer believe that 30 consumers have access to x
D60
D60: if consumer believe that 60 consumers have access to x

D30

A
20
•
B C
10 • •
Pure Market Demand
Price
Effect
Bandwagon Effect

30 38 60 X (units)
Negative  Network  Externality
                           (Snob  Effect)
PX

Market Demand

A
1200
•
C B
900 • • D1000

D1300
Snob Effect

Pure Price Effect X (units)


1000 1300 1800
Next
Production and Cost

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