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Week 4 and 5 chapter notes

Economics for Management Studies
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Chapter 4 Individual and Market Demand Notes
4.1 Individual Demand
The Individual Demand Curve
x price-consumption curve Æ curve tracing the utility-maximizing combinations of two goods as the price of one changes
x this pattern of increasing consumption of a good in response to a decrease in price almost always holds
x individual demand curve Æ curve relating the quantity of a good that a single consumer will buy to its price
x this demand curve has two important properties:
1) The level of utility that can be attained changes moving along the curve. The lower the price of the product, the higher the
level of utility. A higher indifference curve is reached as the price falls.
2) At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the marginal rate of
substitution (MRS) of one good for the other good equals the ratios of the prices of good 1 and good 2. Because the
consumer is maximizing utility, the MRS of good 1 for good 2 decreases moving down the demand curve.
Income Changes
x income-consumption curve Æ curve tracing the utility-maximizing combinations of two goods as a consumer’s income changes
x because every demand curve is measured for level of income, any change in income must lead to shift in the demand curve itself
x the upward-sloping income-consumption cure implies that an increase in income causes a shift to the right in the demand curve
Normal versus Inferior Goods
x when the income-consumption curve has a positive slope, the quantity demanded increases with income
x as result, income elasticity of demand is positivethe greater the shifts to right of demand curve, the larger the income elasticity
x in this case, the goods are described as normal: consumers want to buy more of them as their incomes increase
x in some cases, the quantity demanded falls as income increases; the income elasticity of demand is negative—inferior good
Engel Curves
x Engel curve Æ curve relating the quantity of a good consumed to income
x the upward-sloping Engel curve—like the upward-sloping income-consumption curve—applies to all normal goods
Substitutes and Complements
x for many goods, demand is related to the consumption and price of other goods—complement goods
x other goods tend to substitute for one another—substitute goods
x two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other
x two goods are complements if an increase in the price of one good leads to a decrease in the quantity demanded of the other
x two goods are independent if a change in the price of one good has no effect on the quantity demanded of the other
4.2 Income and Substitution Effects
x a fall in the price of a good has two effects:
1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively
expensive. This response to a change in the relative prices of goods is called the substitution effect.
2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. They are better off
because they can buy the same amount of the good for less money, and thus have money left over for additional purchases.
The change in demand resulting from this change in real purchasing power is called the income effect.
Substitution Effect
x substitution effect Æ change in consumption of a good associated with a change in its price, with level of utility held constant
Income Effect
x income effect Æ change in consumption of good resulting from increase in purchasing power, with relative prices held constant
x the total effect of a change in price is given theoretically by the sum of the substitution effect and income effect:
Total Effect = Substitution Effect + Income Effect
x the direction of the substitution effect is always the same: a decline in price leads to an increase in consumption of the good
x however, the income effect can move demand in either direction, depending on whether the good is normal or inferior
x a good is inferior when the income effect is negative: as income rises, consumption falls
A Special Case: The Giffen Good
x theoretically, the income effect may be large enough to cause the demand cure for a good to slope upward
x Giffen good Æ good whose demand curve slopes upward because (negative) income effect is larger than the substitution effect
x large income effects are often associated with normal rather than inferior goods
4.3 Market Demand
x market demand curve Æ curve relating the quantity of a good that all consumers in a market will buy to its price
From Individual to Market Demand
x two points about market demand curves are—(1) the market demand curve will shift to the right as more consumers enter the
market; and (2) factors that influence the demand of many consumers will also affect market demand
Elasticity of Demand
x denoting quantity of good by Q and its price by P, price elasticity of demand is: EP = (ûQ / Q) / (ûP / P) = (P / Q) (ûQ / ûP)
x when demand is inelastic (EP is less than 1 in absolute value), quantity demanded is relatively unresponsive to changes in price
x as a result, total expenditure on the product increases when the price increases
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