Chapter 3

Demand Curves
 Individual Demand Curves

• This chapter studies how people change their

choices when conditions such as income or
changes in the prices of goods affect the
amount that people choose to consume.
• This chapter then compares the new choices
with those that were made before conditions
changed
• The main result of this approach is to
construct an individual’s demand curve
 Demand Function
Quantity of X demanded = d x ( PX , PY , I ; preferences )

• The three elements that determine the

quantity demanded are the prices of X and Y,
the person’s income (I), and the person’s
preferences for X and Y.
• Preferences appear to the right of the
semicolon because we assume that
preferences do not change during the
analysis.
 Normal Goods

• A normal good is one that is bought in greater

quantities as income increases.
• If the quantity increases more rapidly than
income the good is called a luxury good as
with good Y in Figure 3.1.
• If the quantity increases less rapidly than
income the good is called a necessity good as
with good X in Figure 3.1.
FIGURE 3.1: Effect of Increasing Income on Quantities
of X and Y Chosen

Quantity of Y
per week

Y1
U1
I1
0 X1 Quantity of X
per week
FIGURE 3.1: Effect of Increasing Income on Quantities
of X and Y Chosen

Quantity of Y
per week

Y2

Y1 U2

U1
I1 I2
0 X1 X 2 Quantity of X
per week
FIGURE 3.1: Effect of Increasing Income on Quantities
of X and Y Chosen

Quantity of Y
per week

Y3

Y2 U3

Y1 U2

U1
I1 I2 I3
0 X1 X2 X3 Quantity of X
per week
 Inferior Goods

• An inferior good is one that is bought in

smaller quantities as income increases.
• In Figure 3.2 as income increases from I1 to I2
to I3, the consumption of inferior good Z
decreases.
• Goods such as “rotgut” whiskey, potatoes, and
secondhand clothing are examples of inferior
goods.
FIGURE 3.2: Indifference Curve Map Showing
Inferiority

Quantity of Y
per week

Y1 U1

0 Z1 I1 Quantity of Z
per week
FIGURE 3.2: Indifference Curve Map Showing
Inferiority

Quantity of Y
per week

Y2
U2

Y1 U1
I1 I2
0 Z2 Z1 Quantity of Z
per week
FIGURE 3.2: Indifference Curve Map Showing
Inferiority

Quantity of Y
per week

Y3
U3
Y2
U2
Y1 U1
I1 I2 I3
0 Z3 Z2 Z1 Quantity of Z
per week
 Changes in a Good’s Price

• A change in the price of one good causes both

the slope and an intercept of the budget line
to change.
• The change also involves moving to a new
utility-maximizing choice on another
indifference curve with a different MRS.
• The quantity demanded of the good whose
price has changed changes.
 Substitution Effect

• The part of the change in quantity

demanded that is caused by substitution of
one good for another is called the
substitution effect.
• This results in a movement along an
indifference curve.
• Consumption has to be changed to equate
MRS to the new price ratio of the two goods.
 Income Effect

• The part of the change in quantity demanded

that is caused by a change in real income is
called the income effect.
• The price change also changes “real”
purchasing power and consumers will move to
a new indifference curve that is consistent
with this new purchasing power.
 Substitution and Income Effects
from a Fall in Price
• As shown in Figure 3.3, when the price of
good X falls, the budget line rotates out from
the unchanged Y axis so that the X intercept
lies father out because the consumer can now
buy more X with the lower price.
• The flatter slope means that the relative price
of X to Y (PX/PY) has fallen.
 Substitution Effect from a Fall in
Price
• The consumer was originally maximizing utility
at X*, Y* in Figure 3.3.
• After the fall in the price of good X, the new
utility maximizing choice is X**, Y**.
• The substitution effect is the movement on
the original indifference curve to point B.
FIGURE 3.3: Income and Substitution Effects of a
Fall in Price

Quantity of Y
per week

Y*

U1

0 X* Quantity of X
per week
FIGURE 3.3: Income and Substitution Effects of a
Fall in Price

Quantity of Y
per week

Old budget constraint

Y*
B
New budget constraint
U1

0 X* XB Quantity of X
Substitution per week
effect
FIGURE 3.3: Income and Substitution Effects of a
Fall in Price

Quantity of Y
per week

Y** Old budget constraint

Y* U2
B
New budget constraint
U1

0 X* XB X** Quantity of X
per week
Substitution Income
effect effect
Total increase in X
 Substitution and Income Effects
from an Increase in Price
• An increase in PX will shift the budget line in as
shown in Figure 3.4.
• The substitution effect, holding “real” income
constant, is the move on U2 from X*, Y* to
point B.
• Because the higher price causes purchasing
power to decrease, the movement from B to
X**, Y** is the income effect.
FIGURE 3.4: Income and Substitution Effects of
an Increase in Price

Quantity of Y U2
per week

New budget constraint

Y*
Old budget constraint

0 X* Quantity of X
per week
FIGURE 3.4: Income and Substitution Effects of
an Increase in Price

Quantity of Y U2
per week

U1 B

New budget constraint

Y*
Old budget constraint

0 XB X* Quantity of X
Substitution per week
effect
FIGURE 3.4: Income and Substitution Effects of
an Increase in Price

Quantity of Y U2
per week
U1 B

Y**
New budget constraint
Y*
Old budget constraint

0 X** XB X* Quantity of X
per week
Income Substitution
effect effect
Total reduction
in X
Substitution and Income Effects for
Inferior Goods
• With an inferior good, the substitution effect
and the income effects work in opposite
directions.
• The substitution effect results in decreased
consumption for a price increase and
increased consumption for a price decrease.
Substitution and Income Effects for
Inferior Goods
• The income effect results in increased
consumption for a price increase and
decreased consumption for a price decrease.
• Figure 3.5 shows the two effects for an
increase in PX.
• The substitution effect, holding real income
constant, is shown by the move from X*, Y* to
point B both on U2.
FIGURE 3.5: Income and Substitution Effects for
an Inferior Good

Quantity of Y
per week

Y*
U2
Old budget constraint

0 Quantity of X
X*
per week
FIGURE 3.5: Income and Substitution Effects for
an Inferior Good

Quantity of Y
per week

New budget constraint

Y*
U2
Y**
Old budget constraint

U1
0 Quantity of X
X*
FIGURE 3.5: Income and Substitution Effects for
an Inferior Good

Quantity of Y
per week

New budget constraint

Y*
U2
Y**
Old budget constraint

U1
0 Quantity of X
X** X*
Substitution and Income Effects for
Inferior Goods
• The income effect reflects the reduced
purchasing power due to the price increase.
• Since X is an inferior good, the decrease in
income results in an increase in the
consumption of X shown by the move from
point B on U1 to the new utility maximizing
point X**, Y** on U1.
Substitution and Income Effects for
Inferior Goods
• Since X** is less than X* the price increase in X
results in a decrease in the consumption of X.
• This occurs because the substitution effect, in
this example, is bigger than the income effect.
• Thus, if the substitution effect dominates, the
demand curve is negatively sloped.
 Giffen’s Paradox

• If the income effect of a price change is strong

enough with an inferior good, it is possible for
the quantity demanded to change in the same
direction as the price change.
• Legend has it that this phenomenon was
observed by English economist Robert Giffen.
 Giffen’s Paradox

• When the price of potatoes rose in Ireland the

consumption of potatoes also increased.
• Potatoes were not only an inferior good but
constituted the source of a large portion of
Irish people’s income.
• The situation I which an increase in a good’s
price leads people to consume more of the
good is called Giffen’s paradox.
 Changes in the Price of Another
Good
• When the price of one good changes, it
usually has an affect on the demand for the
other good.
• In Figure 3.3, the increase in the price of X (a
normal good) caused both an income and
substitution effect that caused a reduction in
the quantity demanded of X.
 Changes in the Price of Another
Good
• In addition, the substitution effect caused a
decrease in the demand for good Y as the
consumer substituted good X for good Y.
• However, the increase in purchasing power
brought about by the price decrease causes an
increase in the demand for good Y (also a
normal good).
 Changes in the Price of Another
Good
• Since, in this case, the income effect had a
dominant effect on good Y, the consumption
of Y increased due to a decrease in the price
of good X.
• With flatter indifference curves as shown in
Figure 3.7, the situation is reversed.
• A decrease in the price of good X causes a
decrease in good Y, as before.
 FIGURE 3.7: Effect on the Demand for Good Y of a
Decrease in the Price of Good X

Quantity of Y
per week
Old budget constraint

Y*

U1
0 Quantity of X
X*
per week
 FIGURE 3.7: Effect on the Demand for Good Y of a
Decrease in the Price of Good X

Quantity of Y
per week

Old budget constraint

A
Y*

B New budget constraint

U2
U1
0 Quantity of X
X*
per week
 FIGURE 3.7: Effect on the Demand for Good Y of a
Decrease in the Price of Good X

Quantity of Y
per week

Old budget constraint

A
Y*
C
Y** B New budget constraint
U2
U1
0 Quantity of X
X* X**
per week
 Changes in the Price of Another
Good
• However, in this case, the income effect is
much smaller than the substitution effect so
that the consumer ends up consuming less of
good Y at Y** after the decrease in the price of
X.
• Thus, the effect of a change in the price of one
good has an ambiguous effect on the demand
for the other good.
 Complements

• Complements are goods that go together in

the sense that people will increase their use of
both goods simultaneously.
• Two goods are complements if an increase in
the price of one causes a decrease in the
demanded of the other or a decrease in the
price of one good causes an increase in the
demand for the other.
 Substitutes

• Substitutes are goods that are goods that are

used for essentially the same purpose.
• Two goods such that if the price of one
increases, the demand for the other rises are
substitutes.
• If the price of one good decreases and the
demand for the other good decreases, they
are also substitutes.
Construction of Individual Demand
Curves
• An individual demand curve is a graphic
representation between the price of a good
and the quantity of it demanded by a person
holding all other factors (preferences, the
prices of other goods, and income) constant.
• Demand curves limit the study to the
relationship between the quantity demanded
and changes in the own price of the good.
Construction of Individual Demand
Curves
• In Panel a of Figure 3.8 an individual’s
indifference curve map is drawn using three
different budget constraints in which the price
of X decreases.
• The decreasing prices are P’X, P”X, and P’’’X
respectively.
• The individual’s utility maximizing choices of X
are X’, X’, and X’’’ respectively.
FIGURE 3.8: Construction of an Individual’s
Demand Curve

Quantity of Y
per week Budget constraint for P 9
X

U1

0 X’ Quantity of X
per week
(a) Individual ’s indifference curve map
Price

P’X

0 X’ Quantity of X
per week
(b) Demand curve
FIGURE 3.8: Construction of an Individual’s
Demand Curve

Quantity of Y
Budget constraint for P’X
per week

Budget constraint for P’’X

U2
U1

0 X’ X” X’” Quantity of X
per week
(a) Individual ’s indifference curve map
Price

P’X

P’’X

0 X’ X” Quantity of X
per week
(b) Demand curve
FIGURE 3.8: Construction of an Individual’s
Demand Curve

Quantity of Y
Budget constraint for P’X
per week

Budget constraint for P’’X

Budget constraint for P’’’X

U3
U2
U1

0 X’ X” X’” Quantity of X
per week
(a) Individual ’s indifference curve map
Price

P9
X

P0
X
P-
X

0 X’ X” X’” Quantity of X
per week
(b) Demand curve
FIGURE 3.8: Construction of an Individual’s
Demand Curve

Quantity of Y
Budget constraint for P’X
per week

Budget constraint for P’’X

Budget constraint for P’’’X

U3
U2
U1

0 X’ X” X’” Quantity of X
per week
(a) Individual ’s indifference curve map
Price

P9
X

P0
X
P-
X
d
X

0 X’ X” X’” Quantity of X
per week
(b) Demand curve
 Shifts in an Individual’s Demand
Curve
• When one of the variables that are held
constant (price of another good, income or
preferences) on a demand curve changes, the
entire curve shifts.
• Figure 3.9 shows the kinds of shifts that might
take place.
• If X is a normal good and income increases,
demand increases as shown in Panel a.
FIGURE 3.9: Shifts in Individual’s Demand Curve

PX PX PX

P1 P1
P1

X1 X2 X X1 X2 X X2 X1 X
0 0 0

(a) (b) (c)

FIGURE 3.9: Shifts in Individual’s Demand Curve

PX PX PX

P1 P1
P1

X1 X2 X X1 X2 X X2 X1 X
0 0 0

(a) (b) (c)

 Shifts in an Individual’s Demand
Curve
• If X and Y are substitutes and the price of Y
increases, the demand for X increases as
shown in Panel b.
• Alternatively, if X and Y are complements, the
increase in the price of Y will cause a decrease
in the demand for X as shown in Panel c.
 Shifts in an Individual’s Demand
Curve
• Changes in preferences can also shift demand
curves.
• Panel b could represent an increased
preference for cold drinks when a sudden hot
spell occurs.
• Increased environmental consciousness during
the 1980’s and 1990s increased the demand
for recycling and organic food.
 Be Careful in Using Terminology

• A movement downward along a stationary

demand curve in response to a fall in price is
called an increase in quantity demanded
while a rise in the price of the good results in
a decrease in quantity demanded.
• A rightward shift in a demand curve is called
an increase in demand while a leftward shift is
a decrease in demand.
 Consumer Surplus

• The extra value individuals receive from

consuming a good over what they pay for it is
called consumer surplus.
• Consumer surplus is also what people would
be willing to pay for the right to consume a
good at its current price.
• This concept is used to study the welfare
effects of price changes.
FIGURE 3.10: Consumer Surplus from T-Shirt
Demand Price ($/shirt)

Price
($/shirt)

15 A

11

9
E

B d

10 15 20
Quantity (shirts)
 Market Demand Curves

• The market demand is the total quantity of a

good or service demanded by all potential
buyers.
• The market demand curve is the relationship
between the total quantity demanded of a
good or service and its price, holding all other
factors constant.
 Construction of the Market Demand
Curve
• The market demand curve is constructed by
horizontally summing the demands of the
individual consumers (for private goods).
• Assume the market consists of only two
buyers as shown in Figure 4.1
– At any given price, such as P*X, individual 1
demands X*1 and individual 2 demands X*2.
– The total quantity demanded at the market at P*X
is the sum of the two amounts:
X* = X * 1 + X * 2 .
FIGURE 4.1: Constructing a Market Demand Curve from
Individual Demand Curves

PX PX PX

P*
X

0 X* 0 X* 0 X* X
1 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

Shifts in the Market Demand Curve

• To discover how some event might shift a

market demand curve, we must first find out
how this event causes individual demand
curves to shift and then compare the
horizontal sum of these new demand curves
with the old demand curve.
Shifts in the Market Demand Curve

• For example consider the two buyer case

where both consumers regard X as a normal
good.
• An increase in income for each consumer
would shift their individual demand curves
out so that the market demand curve, would
also shift out
• This situation is shown in Figure 4.2
 FIGURE 4.2: Increases in Each individual’s Income Cause the
Market Demand Curve to Shift Outward

PX PX PX
D

P*
X

0 X* 0 X* 0 X* X
1 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

 FIGURE 4.2: Increases in Each individual’s Income Cause the
Market Demand Curve to Shift Outward

PX PX PX D’
D

P*
X

0 X* X** 0 X* X** 0 X* X** X

1 1 2 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

Shifts in the Market Demand Curve
• An increase in income for pizza lovers would
increase the market demand for pizza so long as
it is a normal good.
• On the other hand, if the increase in income was
for people who don’t like pizza, there would be
no significant effect on the market demand curve
for pizza.
• Changes in the prices of related goods,
substitutes or complements, will also shift the
individual and market demand curves.
 Elasticity
• Goods are often measured in different units (steak is
measured in pounds while oranges are measured in
dozens).
• It can be difficult to make simple comparisons between
goods when trying to determine which is more
responsive to changes in price.
• Elasticity is a measure of the percentage change in one
variable brought about by a 1 percent change in some
other variable.
• Since it is measured in percentages, the units cancel
out so that it is a unit-less measure of responsiveness.
 Price Elasticity of Demand

• The price elasticity of demand is the percentage change in

the quantity demanded of a good in response to a 1 percent
change in its price
• Since, on a typical demand curve, P and Q move oppositely,
eQ,P will be negative.
• For example, if eQ,P = -2, a 1 percent increase in price leads
to a 2 percent decline in quantity.

Percentage change in Q
Price elasticity of demand = eQ ,P =
Percentage change in P
 Terminology for the Ranges of eQ,P

Value of eQ,P at a Point Terminology for Curve

on Demand Curve at This Point
eQ,P < -1 Elastic

eQ,P = -1 Unit elastic

eQ,P > -1 Inelastic

66
Price Elasticity and the Shape of the Demand
Curve

• We often classify market demand curves by

their elasticities
– For example, the market demand curve for
medical services is inelastic (nearly vertical)
since there is little quantity response to
changes in price.
– Alternatively, the market demand curve for a
single type of candy bar is very responsive to
price change (nearly flat) and is very elastic.
 Price Elasticity and the Substitution Effect

• Goods which have many close substitutes are subject

to large substitution effects from a price change so
their market demand curve is likely to be relatively
elastic.
• Goods with few close substitutes, on the other hand,
will likely be relatively inelastic.
• There is also an income effect that will determine how
responsive quantity demanded is to changes in price.
• However, since changes in the prices of most goods
have a small effect on individuals’ real incomes, the
income effect will likely not have as large an impact on
elasticity as the substitution effect.
 Price Elasticity and Time

• Some items can be quickly substituted for,

such as a brand of breakfast cereal, others,
such as heating fuel, may take several years.
• Thus, in some situations, it is important to
make the distinction between the short-term
and long-term elasticities of demand.
Price Elasticity and Total Expenditures

• Total expenditures on a good are found by

multiplying the good’s price (P) times the
quantity purchased (Q).
• When demand is elastic, price increases will
cause total expenditures to fall.
– The given percentage increase in price is more
than counterbalanced by the decrease in quantity
demanded.
 Relationship between Price Changes and Changes in
Total Expenditure

In Response to an In Response to a
Increase in Price, Decrease in Price,
If Demand Is Expenditures will Expenditures will
Elastic Fall Rise

Unit elastic Not change Not change

Inelastic Rise Fall

71
Demand Curves and Price Elasticity

• The relationship between a particular demand

curve and the price elasticity it exhibits can be
complicated.
• For some curves, the elasticity remains
constant everywhere, but for others it is
different at every point.
• A more accurate way to describe it would be
to say the elasticity is for current prices.
 Linear Demand Curves and Price
Elasticity
• The price elasticity of demand is always
changing along a straight line demand curve.
– Demand is elastic at prices above the midpoint
price.
– Demand is unit elastic at the midpoint price.
– Demand is inelastic at prices below the midpoint
price.
 Numerical Example of Elasticity on a
Straight Line Demand Curve
• Assume a straight-line demand curve for
Walkman cassette tape players is
Q = 100 - 2P
– where Q is the quantity of players demanded per
week and P is their price.
• This demand curve is illustrated in Figure 4.3
and Table 4.3 shows several price-quantity
combinations.
FIGURE 4.3: Elasticity Varies along a Linear
Demand Curve

Price
(dollars)
50

40

30
25 Demand
20

10

0 20 40 50 60 80 100 Quantity of tape

players per week
 TABLE 4.3: Price, Quantity, and Total Expenditures on
Walkmans for the Demand Function Q = 100 - 2P

Price (P) Quantity (Q) Total Expenditures (P  Q)

$50 0 $0
40 20 800
30 40 1,200
25 50 1,250
20 60 1,200
10 80 800
0 100 0
 Numerical Example of Elasticity on a
Straight Line Demand Curve
• For prices of $50 or more, nothing is bought
so total expenditures are $0.
• As prices fall between $50 and $25, the
midpoint, total expenditures increase.
• At the midpoint, total expenditures reach a
maximum.
• As prices fall below $25, total expenditures
also fall.
Elasticity of a Straight Line Demand
Curve

• More generally, for a linear demand curve of

the form Q = a - bP,
Q
Q Q P
eQ ,P = = 
P P Q
P
P
eQ ,P = −b  .
Q
 A Unitary Elastic Curve

• Suppose the demand for tape players took

the form
1,200
Q=
P
• The graph of this equation, shown in Figure 4.4,
is a hyperbola.
• P·Q = $1,200 regardless of price so demand is
unit elastic (-1) everywhere on the curve.
General Formula for the Elasticity of a
Hyperbola
• If the demand curve takes the following form,
the price elasticity of demand is equal to b
everywhere on the curve.

Q = aP (b  0)
b

80
 FIGURE 4.4: A Unitary Elastic Demand Curve

Price
(dollars)

60
50
40
30
20

20 24 30 40 60 Quantity of
tape players
per week

81
 Income Elasticity of Demand

• The income elasticity of demand equals the

percentage change in the quantity demanded of
a good in response to a 1 percent change in
income.
• The formula is given by (where I represents
income):
Percentage change in Q
eQ , I = .
Percentage change in I

82
 Income Elasticity of Demand

• For normal goods, eQ,I is positive because

increases in income lead to increases in
purchases of the good.
• For inferior goods eQ,I is negative.
• If eQ,I > 1, the purchase of the good increases
more rapidly than income so the good might
be called a luxury good.

83
Cross-Price Elasticity of Demand

• The cross-price elasticity of demand

measures the percentage change in the
quantity demanded of a good in response to
a 1 percent change in the price of another
good. Letting P’ be the price of another
good,
Percentage change in Q
eQ ,P = .
Percentage change in P'
84
Cross-Price Elasticity of Demand

• If the goods are substitutes, an increase in

the price of one will cause buyers to
purchase more of the substitute, so the
elasticity will be positive.
• If the goods are complements, an increase
in the price of one will cause buyers to buy
less of that good and also less of the good
they use with it, so the elasticity will be
negative 85
 Empirical Studies of Demand:
Estimating Demand Curves
• Estimating a demand curve for a product is
one of the more difficult but important
problems in econometrics.
• Empirical studies are useful because they
provide a more precise estimate of the
amount of change in quantity demanded that
results due to a price change.

86
 Problems Estimating Demand Curves

• The first problem is how to derive an estimate holding all

other factors (the ceteris paribus assumption) constant.
– This problem is often solved, as discussed in the Appendix to Chapter
1, by the use of multiple regression analysis.
• The second problem deals with what is observed in the data.
The data points represent quantity and price outcomes that
are simultaneously determined by both the demand and the
supply curves.
– The econometric problem is to “identify” from these equilibrium
points the demand curve that generated them.

87