Chapter 5

Deriving Individual Demand Curves

• In Chapter 4, consumer’s optimal basket was determined.
• Thus, we can tell – for a given income and prices of other goods –
how much a consumer will demand of X for a given price of X.
• This is a point on the consumer’s demand curve.
• We can find more points on the demand curve for X by changing the
price of X and determining how much of X the consumer will demand
– prices of other goods and income are held constant.

The Price Consumption Curve of Good X: Is the set of optimal baskets

for every possible price of good x, holding all other prices and income
constant.

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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, it causes the consumer to move down and to
the right along the demand curve as utility increases in that direction.
 The demand curve is also the “willingness to pay” curve – and
willingness to pay for an additional unit of X falls as more X is
consumed.

Algebraically, we can solve for the individual’s demand using the following
equations
1. pxx + pyy = I – on the budget line
2. MUx/px = MUy/py – at a tangency.

Income Consumption Curve

The income consumption curve of good x is the set of optimal baskets for
every possible level of income.
We can graph the points on the income consumption curve as points on a
shifting demand curve.

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Definitions of Goods

If the income consumption curve shows that 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.

If the income consumption curve shows that 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.

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The consumption response to a change in the price of another good

If X1* ↑ as P2 ↑, then we say that good 1 is a for good 2

If X1* ↓ as P2 ↑, then we say that good 1 is a for good 2

Impact of Change in the Price of a Good

• Holding tastes, other prices, and income constant, an increase in the

price of a good has two effects on an individual’s demand:

Substitution Effect: Relative change in price affects the amount of

good that is bought as consumer tries to achieve the same level of
utility
• 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.

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Income Effect: Consumer’s purchasing power changes and affects the

consumer in a way similar to effect of a change in income
• As the price of x falls, all else constant, purchasing power rises. As
the price of x rises, all else constant, purchasing power falls.
This is called the income effect of a change in price.
The income effect may be positive (normal good) or negative (inferior
good).

When the price of a good changes, the total change in quantity demanded is
the sum of the substitution and income effects.
Total effect = Substitution effect + Income effect

How to show SE and IE on a diagram:

• Beginning from budget constraint L1, a decrease in the price of X

rotates budget constraint into L2.
• The total effect of this price change is an increase in quantity of
X from XA to XB. This increase in quantity can be decomposed
into income and substitution effects.

Let’s begin by isolating the SE. This part of the change in

quantities demanded is due only to the change in relative prices not
to the change in consumer’s purchasing power. We can do this by
holding consumer’s purchasing power same as before the price
change. What bundle would consumer buy if after the price
change, there was no income effect that is if he had the same
purchasing power as before the price change and felt neither poorer
or richer?
-For consumer to not feel richer and poorer, the bundle he
chooses after the price change must provide the same utility as
before the price change.
-This bundle must also reflect that the relative price has
changed, so must have the same slope as the new BL.

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**Important- we never really observe BL3 or bundle C. Only choices A and

B are made.

Now to isolate the IE, we must hold relative price at their new level and
only allow the purchasing power to change. Remember to find bundle C, we
shifted the new BL back to take away the change in purchasing power.
Doing that shift in reverse is then the IE.

Notice that in the diagram we drew above, X was a normal good because

When X is normal, SE and IE work in the same direction:

IE and SE with an Inferior Good

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Chapter 5

As in diagram (b) above, if a good is so inferior that the net effect of a price
decrease of good x, all else constant, is a decrease in consumption of good
x, good x is a Giffen good.
For Giffen goods, demand does not slope down.
When might an income effect be large enough to offset the substitution
effect? The good would have to represent a very large proportion of the
budget.

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Negative SE
If IC are convex to the origin, and if consumer buys positive quantity of both
goods, the SE is always negatively related to the price change.

Holding U constant, as Px/Py

consumer always substitutes the
relatively cheaper X for the
relatively expensive Y.

Example – Income and Substitution Effects

Suppose U(x,y) = xy  MUx = , MUy =

Py = $1/unit and I = $72
Suppose that Px1 = $9/unit. What is the (initial) optimal consumption
basket?
We derived the demand functions for X and Y for this utility function:

Solving: x = 4 and y = 36

Suppose that price of x falls and Px2 = $4/unit. What is the (final) optimal
consumption basket?

Solving: x = 9 and y = 36

Find the decomposition basket B.

1. It must lie on the original indifference curve U1 along with basket A
 U1 = XY = 4(36) = 144.
2. It must lie at the point where the decomposition budget line is tangent
to the indifference curve.
3. Price of X (PX) on the decomposition budget line is final price of $4.

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Consumer Surplus
• The individual’s demand curve can be seen as the individual’s
willingness to pay curve.
• On the other hand, the individual must only actually pay the market
price for (all) the units consumed.
• Consumer Surplus is the difference between what the consumer is
willing to pay and what the consumer actually pays.

Definition: The net economic benefit to the consumer due to a purchase (i.e.
the willingness to pay of the consumer net of the actual expenditure on the
good) is called consumer surplus.
The area under an ordinary demand curve and above the market price
provides a measure of consumer surplus

• If the price of a good rises (e.g. $0.50 to $1), purchasers of that good
lose
• The shaded area is the decrease in CS. This shows the amount of
income we would have to give the consumer to offset the harm of an
increase in price.

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Understanding Consumer Surplus from the Optimal Choice Diagram:

Companseting Variation (CV) and Equivalent Variation(EV)
As we have seen, a price change impacts the well-being of a consumer. But
there is no natural measure of the units of utility, so what economists do is
measure the impact in monetary terms.
2 equally valid ways of measuring the impact of
• Compensating variation is the amount of money we would
have to give a consumer after a price increase to keep the
consumer on their original indifference curve.

• Equivalent variation is the amount of money we would have to

take away from a consumer to harm the consumer as much as
the price increase did.

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