PPA 723: Managerial Economics

1
PPA 723 Managerial Economics

• Lecture 8
• Deriving Demand Curves

2
Managerial Economics, Lecture 8 Deriving Demand
Curves

• Outline
• Deriving Demand Curves
• Income Elasticities of Demand
• Income and Substitution Effects

3
Managerial Economics, Lecture 8 Deriving Demand
Curves
Deriving Demand Curves

• Trace out the demand curve for Good B from a
  household-maximization diagram by
• holding income and the price of Good A constant
• and varying the price of Good B
• Then plot the price-quantity pairs in a new graph.

4
Managerial Economics, Lecture 8 Deriving Demand
Curves
Pulling Out Price and Quantity Combinations

Price of Pizza Doubles
B
, Burritos
per semester
25
1
L
(
p
1)
Z
Price-Consumption Curve
2
L
(
p
2)
Z
15
50
25
0
27
Z
, Pizzas per semester
5
Managerial Economics Deriving Demand Curves
(a) Indifference Curves and Budget Constraints
Wine, Gallons
per year

12.0

Price-consumption curve
e
3
Figure 5.1 Deriving an Individuals Demand Curve
5.2
e
2
4.3
I
3
e
1
2.8
I
2
I
1
1
12)
L
(
p
L
2
(
p
6)
L
3
(
p
4)
b
b
b
0
26.7
44.5
58.9
Beer, Gallons per year
p
, per unit
(b) Demand Curve
b
12.0
E
1
E
6.0
2
E
3
4.0
D
1
, Demand for beer
26.7
0
44.5
58.9
Beer, Gallons per year
6
Managerial Economics, Lecture 8 Deriving Demand
Curves
How Income Changes Shift Demand Curves

• In household-maximization diagram, hold prices
  fixed and vary income.
• The increase in income causes
• movement along the income-consumption curve,
• shift of the demand curve,
• movement along the Engel curve.

7
Managerial Economics, Lecture 8 Deriving Demand
Curves
Income-Consumption Curve

• An increase in income shifts the budget line
  outward.
• An income-consumption curve plots combinations of
  Good A and Good B at different income levels.

8
Managerial Economics, Lecture 8 Deriving Demand
Curves
Shifts in the Demand Curve

• Recall that a demand curve plots price-quantity
  combinations for one good.
• A change in income changes the quantity for a
  good, holding price constant.
• So at each price, plot how quantity consumed
  increases with income.

9
Managerial Economics, Lecture 8 Deriving Demand
Curves
Engle Curves

• An Engle curve plots quantity consumed for a good
  (X-axis) against income (Y-axis), holding prices
  constant.
• It shows how consumption of a good changes as
  income changes.

10
Managerial Economics, Lecture 8 Deriving Demand
Curves
Pulling Out Income and Quantity Combinations

Income Doubles
B
, Burritos
per semester
50
3

L
(
Y
100)
Income-Consumption Curve
25
1

L
(
Y
50)
25
100
50
0
55
Z
, Pizzas per semester
11
Managerial Economics, Lecture 8 Deriving Demand
Curves
(a) Indifference Curves and Budget Constraints
Wine, Gallons
3
L
per year
2
L
Income-consumption
1
L
curve

e
3
7.1
e
4.8
2
3
I
Figure 5.2 Effect of a Budget Increase on an
Individuals Demand Curve
e
2.8
2
1
I
1
I
0
49.1
38.2
26.7
Beer, Gallons per year
(b) Demand Curves
Price of beer,
per unit
E
E
E
3
1
2
12
3
D
2
D
1
D
0
49.1
38.2
26.7
Beer, Gallons per year
(c) Engel Curve
Y
, Budget
Engel curve for beer
Y
837
E

3
3
Y
628
E

2
2
Y
419

E
1
1
0
49.1
38.2
26.7
Beer, Gallons per year
12
Managerial Economics, Lecture 8 Deriving Demand
Curves
Income Elasticities

• Income elasticity
• Normal good ? gt 0
• Inferior good ? ? 0
• Note ? is Greek xi (pronounced ks-eye).

13
Managerial Economics, Lecture 8 Deriving Demand
Curves
Income-Consumption Curves and Income Elasticities

• The shape of the income-consumption curve for 2
  goods reveals the sign of the income
  elasticities.
• Some goods must be normal not all goods can be
  inferior.

14
Managerial Economics, Lecture 8 Deriving Demand
Curves
Figure 5.3 Income-Consumption Curves and Income
Elasticities
Housing, Square feet
per year
Food inferior,
housing normal
1
ICC
2
L
a
Food normal,
housing normal
2
ICC
b
1
L
e
c
Food normal,
3
ICC
housing inferior
I
Food, Pounds per year
15
Managerial Economics, Lecture 8 Deriving Demand
Curves
Applications to Policy

• Policy makers may care about the consumption of
  particular goods, such as health care or housing.
• If we know income elasticities, we can predict
  the extent to which people buy more of these
  goods when
• they receive a cash grant
• incomes in general rise.

16
Managerial Economics, Lecture 8 Deriving Demand
Curves
The Effects of a Price Change

• As price of Good A goes up (all else the same),
  there are two impacts in the quantity of Good A
  that is consumed
• the substitution effect
• the income effect

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Managerial Economics, Lecture 8 Deriving Demand
Curves
Substitution Effect

• Consumers substitute other, now relatively
  cheaper, goods for the good subject to a price
  increase.
• The direction of the substitution effect is
  unambiguous It is always negative!

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Managerial Economics, Lecture 8 Deriving Demand
Curves
Income Effect

• An increase in the price of Good A reduces a
  consumers' buying power, thereby reducing his or
  her real income.
• A change in real income is equivalent to a change
  in money income holding prices constant, so
• The direction of the income effect depends on the
  income elasticity of Good A

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Managerial Economics, Lecture 8 Deriving Demand
Curves
Income and Substitution Effects

price rise substitution effect income effect
normal good negative negative
inferior good negative positive
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Managerial Economics, Lecture 8 Deriving Demand
Curves
Figure 5.5 Substitution and Income Effects with
Normal Goods
Wine, Gallons
per year

12.0
2
L
1
L
e
5.5
2
L

2
I
e
1
e

1
I
0
58.9
26.7
30.6
Beer, Gallons per year
Substitution
Income effect
effect
Total effect
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Managerial Economics, Lecture 8 Deriving Demand
Curves
Income and Substitution Effects with an Inferior
Good

• The substitution effect and the price change
  still have opposite signs.
• The income effect and the price change have the
  same signs.
• A Giffen good good for which a decrease in its
  price causes the quantity demanded to fall
  (because the positive income effect is so large!)

22
Managerial Economics, Lecture 8 Deriving Demand
Curves
Figure 5.6 Giffen Good
Basketball,
Tickets per year
2
L
e
1
L
2
2
I
L

e
1
e

1
I
Total effect
Substitution effect
Movies, Tickets per year
Income effect
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Managerial Economics, Lecture 8 Deriving Demand
Curves

• Income and Substitution Effects Lessons
• Income and substitution effects help identify
  consumers responses to changes in prices.
• As we will see next time, they are very useful in
  predicting consumers responses to government
  programs that alter prices (as many do!).