WHY DOES THE DEMAND CURVE SLOPE DOWNWARD?

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WHY DOES THE DEMAND CURVE SLOPE DOWNWARD?
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REASONS FOR THE DOWNWARD SLOPING DEMAND CURVE
INCOME EFFECT the change in consumption that
results from the movement to a higher
indifference curve. SUBSTITUTION EFFECT the
change in consumption that results from being on
an indifference curve with a marginal rate of
substitution.
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THE INCOME EFFECT
Suppose a consumer makes 1000 a month and spends
all of his money on either Pizza or Pepsi.
Q of Pepsi
The graph shows the amount the consumer could
afford if the price of Pepsi is 2 and the price
of pizza is 10.
500
Q of Pizza
100
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THE INCOME EFFECT
The point where he spends exactly 500 on each is
Q of Pepsi
Because slope is
This line is called budget constraint.
500
Vertical distance Horizontal distance
250
This would mean 500/100 or 5 pepsi to 1 pizza.
Q of Pizza
100
50
(We ignore the minus sign.)
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Draw the budget constraint for a person with
income of 1000 if the price of Pepsi is 5 and
the price of pizza is 10.
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THE SUBSTITUTION EFFECT
An indifference curve shows the bundles of
consumption that make the consumer equally happy.
Q of Pepsi
C
In this case, the indifference curves show the
combinations of Pepsi and pizza it would take to
make the consumer happy.
D
B
I2
A
I1
Q of Pizza
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A substitute good is defined as a good that, when
its price rises causes a increase in the demand
of another good (or visa versa). Substitute goods
have a direct relationship between price of one
good and demand for another. Pa Db Pa Db
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A complementary good is defined as a good that,
when its price rises causes a decrease in the
demand of another good (or visa
versa). Complementary goods have an inverse
relationship between price of one good and demand
for another. Pa Db Pa Db
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THERE ARE FOUR PROPERTIES OF THE INDIFFERENCE
CURVE
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1) Higher indifference curves are preferred to
lower ones.
Q of Pepsi
Consumers usually prefer more to less. Therefore,
a consumer would prefer point D to point A
because it is on a higher indifference curve.
C
D
B
I2
A
I1
Q of Pizza
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2) Indifference curves are downward sloping.
The IC reflects the rate at which consumers are
willing to substitute one good for another.
Therefore, if Q of one good is reduced, then the
Q of the other must increase to make the consumer
equally happy.
Q of Pepsi
C
D
B
I2
A
I1
Q of Pizza
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3) Indifference curves do not cross.
This could never happen. According to these
indifference curves, the consumer would be
equally happy at points A, B, and C, even though
point C has more of both goods.
Q of Pepsi
A
C
B
Q of Pizza
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4) Indifference curves are bowed inward.
This shape implies that the marginal rate of
substitution (MRS) depends on the Q of the two
goods the consumer is consuming. When IC are less
bowed, the goods are easy to substitute for each
other.
Q of Pepsi
MRS 6
14 8 4 3
B
MRS 1
A
I1
Q of Pizza
2 3 6 7
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The effect of a price change can be broken down
in to the income effect and the substitution
effect.
Point A is the initial optimum, and the movement
along the IC to point B represents the
Substitution Effect.
Q of Pepsi
C
B
The Income Effect is shown in the movement from
point B to point C.
A
Q of Pizza
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To derive the DEMAND CURVE, notice that when the
price of Pepsi falls from 2 to 1.
Q of Pepsi
the consumers optimum moves from point A to B,
and the optimum quantity of Pepsi consumed rises
from 250 to 750.
B
750 250
A
Q of Pizza
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Therefore, the demand curve reflects this
relationship between price and quantity.
Price of Pepsi
A
2 1
B
Quantity of Pepsi
250 750
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PowerPoint created by Virginia Meachum Source
Principles of Economics, Third Edition, by N.
Gregory Mankiw.