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More Demand theory Ch. 4.doc

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McMaster University
Hannah Holmes

More Demand theory Ch. 4 (Only 4.1, 4.2 & 4.3) Fred Aswani Econ 2GG3 • 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 1 2 not nominal price. Speculation is one example that shows that relative prices are the e 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 Spain. 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. Problem 4.1. 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 fallen.  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 elasticity -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 column?” 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. Price Increase To see these effects graphically, for the 2 good case, consider Fig. 4.2. P.117. Figure 4.2. 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
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