3: Demand Flashcards
income expansion path
how the optimal bundle changes as income changes
x2 vs. x1 space
engel curve
how optimal consumption of one good changes as income changes
m vs. x1 space
normal good
as income increases, demand increases
positive engel slope
inferior good
as income increases, demand decreases
negative engel slope
offer curve
how the optimal bundle changes as price changes
x2 vs. x1 space
ordinary good
as price increases, demand decreases
demand curve slopes down
giffen good
as price increases, demand increases
demand curve has a positive slope
substitutes
demand for one good increases as the price of the other good increases
dx1*/dp2 > 0
complements
demand for one good decreases as the price of the other good increases
dx1*/dp2 < 0
total price change decomposed into
substitution effect and income effect
effect of PP change and relative price change
substitution effect
relative price effect
if the relative price of two goods change, we expect the consumer’s new bundle to include more of the cheaper good at the expense of the more expensive good
Z - X
income effect
PP effect
- similar to an income change
if the relative price of a good changes and income stays the same, we expect the consumer’s new bundle to include more of both goods because the consumer is “richer”
Y - Z
slutsky decomposition question
what if a consumer faced a budget line with the same slope (prices are the same relative prices) but they can still afford the original bundle?
slutsky decomposition
controlling for PP since you can afford original prices but relative prices are different
start with old budget and optimal point x
draw new budget line after price change and new optimal point y
draw hypothetical budget with same slope as new budget which crosses x
substitution and income effect in slutsky decomposition
substitution effect must be negative if preferences are monotonic
- when price increases, substitution effect is to consume less
- when price decreases, substitution effect is to consume more
income effect can go either way
- depends on whether the good is normal or inferior
- if the income effect is strong in the opposite direction to the substitution effect, we have a giffen good
hicks decomposition question
what if a consumer faced a new price ratio but their optimal choice was on the same indifference curve as before?
start with old budget line and optimal point x
draw new budget line after price change and new optimal point y
draw hypothetical budget line with same slope as the new budget line which is tangent to the old IC
slutsky vs. hicks
slutsky is useful since its based on observables and not utility
- decomposed by focusing on affordability of the old bundle after the price change
hicks is useful to measure welfare changes and compensation
- decomposed by focusing on utility of the old bundle after price change
- 2 ICs
- harder to measure in the real world
PED
% change in QD / % change in P
the steeper the demand curve, the more inelastic
PED equation
- dx1/p1 (p1/x1)
PED < 1
inelastic demand
% demand response is smaller than % price change
PED > 1
elastic demand
% demand response is bigger than % price change
income expansion path for cobb-douglas function
higher weight on good 1 than good 2 on the utility function makes the liner flatter
lower price of good 1 also makes the liner flatter
if p1=p2 and there are equal weights, the consumer always spends half their income no each good
- 45 degree line from origin
when is the substitution effect 0?
optimal choice on the hypothetical budget line exactly the same as the optimal choice on the original budget line
MRS > p1/p2
there are bundles above that are preferred
willing to give up more than necessary (by price constraint)
