More Demand theory Ch. 4 (Only 4.1, 4.2 & 4.3)
• In Chapter 3 we focused on the consumer's choice problem and
further discussed the comparative statics. We for example,.
examined what happens to x when 1ts own price, p changes.1
• In general economists agree that demand curves are downward
sloping-This is referred to as the law of demand. Why?
That in order to induce an increased consumption of the good, its
price has to be reduced.
See discussion on p.111-112. Vegetables in summer, zellers prices
& Hunt brothers with silver prices. Note that for Hunter bros as
the price increased they demanded more silver? Is it contrary to the
law of demand? No. This is speculation.
• Note that what actually matters is the relative price (p /p ) and
not nominal price.
Speculation is one example that shows that relative prices are the
ones that matter. What matters is p today/p tomorrow. Where the
1 superscript e refers to expected price. If p today=Pe=8 then telative
price is 1. However, for speculators if price today is say 8 and
expected price tomorrow is say 50 then the relative price is 0.16. A
speculator will therefore buy more today expecting price to be
higher tomorrow. Relative price today actually falls.This is
consistent with a downward sloping demand curve.
• Another fine example of the law of demand is referred to as the
Alchian Allen theorem.
Example: Suppose that in Spain high Quality Sandals (Price=$10)
and low quality Sandals ($5). Relative price of high quality sandals
is 2 low quality sandals. Suppose it costs $10 to ship Sandals to the
N,America. Now relative price in N.America is 20/15=1.33
Therefore there will be a higher proportion of high quality sandals
to low quality sandals consumed in N. America than in Spain.
Though fewer Sandals will be consumed in N.America than in
Conclusion: “adding fixed charge to two qualities of the same
good raises the nominal price of each, but lowers the relative price
2 of the high quality good”. This is referred to as the Alchian Allen
theorem-See textbook discussion on this p115-116.
Before parking fee relative price of good car is 2 bad cars.
After parking fee relative price is 1200/700 <2. Fewer cars will be
parked but more of the expensive ones since its relative price has
See also the Salmon example in textbook.
Please read also through discussion on objections to the law of
demand. p. 114:
Necessities-price goes up you buy about the same amount-low
-how about suicides and cost of suicides-does life insurance which
reduces cost of suicides lead to an increase in suicide rates?
-How about car insurance, air bags and seat belts with accidents?
“How fast would you drive if rather than an air bag and seat belt,
you had a six inch dagger coming at you from the steering
3 4.2. Income and Substitution effects.
• Is there a case when law of demand is violated? Figure 4.1
suggests that it is possible that as the price increases quantity
demanded may also increase. This must mean that the demand
curve for x 1s upward sloping. -
Q. How is that possible?
A. x 1s a giffen good- A good, for which the quantity demanded
rises/falls as the price rises/falls.
♦ Note that we are talking about the relation between p and q for
only one consumer. Only if all consumers demanded more as
the price goes up would we know for sure that this demand
curve can be generalized to the aggregate level.
The demand curve for the giffen good is traced out by changing the
price of the good, and seeing how much of it is demanded when
the individual's IC is tangent to the BC. The IC's are only tangent
to the relevant BC at only one point.
4 • Note too that the individual does not need to have perverse
(non-convex) indifference orderings for one of the goods in
his/her consumption bundle to be a giffen good. The IC's satisfy
all axioms that are discussed in Chapter 2. Which ones are they?
• It may be that the good is giffen only over a certain range of
prices and quantities. Therefore the demand curve will generally
not be an upward sloping at all prices.
• To understand how an upward sloping DD curve might be
possible we decompose the effect of a price change on quantity
into two parts-substitution and income effects.
Substitution effect-Pure price effect. Concern with the relative
price of good 1. The good whose price has risen is now more
expensive relative to others. The individual will tend to want to
switch towards getting utility from other goods in the consumption
bundle that are relatively cheaper
Income effect- with unchanged income if price of one good ,for
example, falls the individual can afford to consume more of both.
5 There is a change is his/her in real income. If price falls this
increases the consumer's purchasing power (equivalent to
increased income). Thus if the consumer were to purchase the
same bundle as before he would have more income left over that
he can now spend on both goods. Implies that the set of attainable
consumption bundles expands.
To see these effects graphically, for the 2 good case, consider Fig.
Initially: p1=1 p2=1 M=60 Consumer chooses point A.
P 1ncreases to 3. Consumer chooses point C. This is the total
effect of the price change. x d1clines by 18 units.
To distinguish between income and substitution effects, suppose
there is only a relative price effect (no change in the ability to
purchase). Thus we are looking for the substitution effect only.
• Now give the consumer enough income (compensatory income)
to enable him be on the original indifference curve-This result in
6 the compensated budget line. Compensate the individual for the
relative price change to the extent that he/she obtains the same
level of utility as before. This is found at point D. How much
income is the consumer compensated?
Total expenditure at D=66 + 44=110 (R