Chapter Summary

Our focus in this chapter was on how individual and market demands respond to variations in prices and incomes. To generate a demand curve for an individual consumer for a specific good X, we first trace out the price-consumption curve in the standard indifference curve diagram. The PCC is the line of optimal bundles observed when the price of X varies, with both income and preferences held constant. We then take the relevant price-quantity pairs from the PCC and plot them in a separate diagram to get the individual demand curve.

The income analogue to the PCC is the income-consumption curve, or ICC. It too is constructed using the standard indifference curve diagram. The ICC is the line connecting optimal bundles traced out when we vary the consumer's income, holding preferences and relative prices constant. The Engel curve is the income analogue to the individual demand curve. We generate it by retrieving the relevant income-quantity pairs from the ICC and plotting them in a separate diagram.

Normal goods are those the consumer buys more of when income increases and inferior goods are those she buys less of as income rises.

The total effect of a price change can be decomposed into two separate effects: (1) the substitution effect, which denotes the change in the quantity demanded that results because the price change makes substitute goods seem either more or less attractive, and (2) the income effect, which denotes the change in quantity demanded that results from the change in real purchasing power caused by the price change. The substitution effect always moves in the opposite direction from the movement in price: price increases [reductions] always reduce [increase] the quantity demanded. For normal goods, the income effect also moves in the opposite direction from the price change, and thus tends to reinforce the substitution effect. For inferior goods, the income effect moves in the same direction as the price change, and thus tends to undercut the substitution effect.

The fact that the income and substitution effects move in opposite directions for inferior goods suggests the theoretical possibility of a Giffen good, one for which the total effect of a price increase is to increase the quantity demanded. There have been no documented examples of the existence of Giffen goods, and in this text we adopt the convention that in the standard case, all goods are demanded in smaller quantities at higher prices. Giffen goods are analyzed in the appendix to this chapter.

Goods for which purchase decisions respond most strongly to price tend to be ones that have large income and substitution effects that work in the same direction. For example, a normal good that occupies a large share of total expenditures and for which there are many direct or indirect substitutes will tend to respond sharply to changes in price. For many consumers, housing is a prime example of such a good. The goods least responsive to price changes will be those that account for very small budget shares and for which substitution possibilities are very limited. For most people, salt has both of these properties.

There are two equivalent techniques for generating market demand curves from individual demand curves. The first is to display the individual curves graphically and then add them horizontally. The second method is algebraic and proceeds by first solving the individual demand curves for the respective Q values, then adding those values, and finally solving the resulting sum for P.

A central analytical concept in demand theory is the price elasticity of demand, a measure of the responsiveness of purchase decisions to small changes in price. Formally, it is defined as the percentage change in quantity demanded that is caused by a 1 percent change in price. Goods for which the absolute value of elasticity exceeds 1 are said to be elastic; those for which it is less than 1, inelastic; and those for which it is equal to 1, unit elastic.

Another important relationship is the one between price elasticity and the effect of a price change on total expenditure. When demand is elastic, a price reduction will increase total expenditure; when inelastic, total expenditure falls when the price goes down. When demand is unit elastic, total expenditure is at a maximum, as a (small) reduction in price is exactly offset by the increase in quantity demanded.

The value of the price elasticity of demand for a good depends largely on four factors: substitutability, budget share, direction of income effect, and time. (1) Substitutability. The more easily consumers may switch to other goods, the more elastic demand will be. (2) Budget share. Other factors the same, goods accounting for a large share of total expenditures will have greater income effects. (3) Direction of income effect. Other factors the same, inferior goods will tend to be less elastic with respect to price than are normal goods. (4) Time. Habits and existing commitments limit the extent to which consumers can respond to price changes in the short run. Price elasticity of demand will tend to be larger, the more time consumers have to adapt.

Changes in the average income level in a market will generally shift the market demand curve. The income elasticity of demand for a good X is defined analogously to its price elasticity. It is the percentage change in quantity demanded that results from a 1 percent change in income. Goods whose income elasticity of demand exceeds zero are called normal goods; those for which it is less than zero are called inferior; those for which it exceeds 1 are called luxuries; and those for which it is less than 1 are called necessities. For normal goods, an increase in income will shift market demand to the right; and for inferior goods, an increase in income will shift demand to the left. For some goods, the distribution of income, not just its average value, is an important determinant of market demand.

The cross-price elasticity of demand is a measure of the responsiveness of the quantity demanded of one good to a small change in the price of another. Formally, it is defined as the percentage change in the quantity demanded of one good that results from a 1 percent change in the price of the other. If the cross-price elasticity of demand for X with respect to the price of Z is positive, X and Z are substitutes; and if negative, they are complements. In remembering the formulas for the various elasticities-own price, cross-price, and income-many people find it helpful to note that each is the percentage change in an effect divided by the percentage change in the associated causal factor.

The appendix to this chapter examines additional topics in demand theory, including the constant elasticity demand curve, arc elasticity, the income-compensated demand curve, and Giffen goods.