Review

Individual Change only the price of x

demand curve and see how demand changes

Optimal For given prices and income we can

solve for the consumer’s optimal bundle
Bundle

Consumer’s
Problem
 Review
2

Y: Composite good Price Consumption

PX1 X1

PX2 X2

PX3 X3
•A
•B
•C

x1 x2 x3 X
I/PX3
I/PX1 I/PX2
 Review

Price Consumption
Price
PX1 X1

•
PX2 X2
•
PX3 X3
P
 X1 •

P
 X2 •
•

P
 X3 •
•

0 X1 X2 X3
Quantity
 Review
How does the consumption of x changes with the
Y: Composite good income?
I3/Py
Income Consumption
I2/Py
I1 X1
I1/Py
I2 X2
A B •C
• •
I3 X3

x1 x2 x3 X
I3/PX
I1/PX I2/PX
Review

The Engel Curve for good x is the quantity

I ($) consumed of good x for any income level.

Engel Curve

92

68

40

0 10 18 24
X (units)
 Change in prices
6

The plan: Understand how a change in

Price price influences demand.
Question:
• Why does a decrease in price from
PX1 to PX2 lead to a consumption
increase of:
•
X2-X1,
 X1P • whereas a decrease in price from
PX2 to PX3 lead to a consumption
increase of:
P
 X2 •
• X3-X2
P
 X3 •
?
•

0 X1 X2 X3
Quantity
 Change in prices
7

Example Suppose the price of x is PX =2 and the price of y is Py =1, both Daniel
and Isabel have the same income I=12

For Daniel the goods are perfect substitutes: U=x+y

For Isabel the goods are perfect compliments: U=min[x,y]
Question: What is Daniel’s optimal bundle? What is Isabel's optimal bundle?

- Daniel would spend his entire income on good y, consuming 12 units of y

- Isabel purchases and equal amount of both goods, consuming 4 units of x and 4
units of y

Question: Suppose price of y increase from 1 to 4, Py =4. How do Daniel and Isabel
adjust their consumption?

- Daniel would now spend his entire income on good x, consuming 6 units of x
- Isabel would still spend her income equally on both goods, consuming 2 units of x
and 2 units of y
 Change in prices
8

Example Daniel substitutes all 12 units of y for 6 units of x. Isabel

Y: Composite good decreases both x and y proportionately

12 •
If the price of y increases two things happen:

1. Good x is cheaper compared to good y, pushes

Daniel towards more x (Think of Daniel)

2. Consumers have less money to spend, and can

not afford to purchase as much x and y
(Think of Isabel)
4 •
3 Isabel
2 •

• X
2 4 6
 Change in prices
9

Decompose a change in price to two effects:

1. Substitution effect

2. Income effect
 Change in prices
10

Key point: When price of x falls, consumption changes from x1 to

Y x2. There are two factors that influence this change:

1. x becomes cheaper relative to y. So the consumer substitutes y

for more x
x2 –x1 2. Purchasing power increases the consumer can buy the same
amount and still have money left

We want to know how much of the consumption change

is due to the change in relative prices and how much is
•A due to the increase in purchasing power.
•B

x1 x2 X
I/PX1 I/PX2
 The substitution and income effects
11

Initially, optimal bundle is A=(xA,yA). If price of x drops and bundle B=(xB,yB) becomes
optimal. How much is due to substitution and how much due to income effect?
Idea: use a decomposition basket.
Y: Composite good “Suppose that under the new prices
income adjusts to keep the consumer just
as well off as initially (that is, on the initial
IC). What would be the optimal basket?”

The answer is the decomposition basket,

Decomposition D=(xD,yD).
basket

•A
D
• •B

X
I/PX1 I/PX2
 The substitution and income effects
12

Initial bundle is A=(xA,yA), final bundle B=(xB,yB) and decomposition basket D=(xD,yD).
The substitution effect is the difference between
the amount of good consumed in D and A:
Y: Composite good xD-xA is (own-good) SE.

The income effect is the difference between the

amount of good consumed in B and D:
xB-xD is (own-good) IE.
Decomposition The cross-good effects are yD-yA and yB-yD
basket respectively.

yA •A Income effect
yB
yD
D
• •B

Substitution effect

xA xD xB X
I/PX1 I/PX2
 Change in prices
13

The income effect on x can either be

Substitution effect
positive or negative depending on whether
good x is normal or inferior
A Income effect
•
D
• •B

x1 x2 X
I/PX1 I/PX2
 Example 1
14

Suppose that price of x is Px1 = 9 € and price of y is Py = 1 € and income I=72 €.

The utility function is U(x,y) = xy

a. What is the (initial) optimal consumption basket?

b. Suppose that price of x falls and Px2 = 4 €. What is the (final) optimal
consumption basket?

c. Find the decomposition basket. What is the substitution effect? What is the
income effect?
 Example 1
15

a. When Px1 = 9 € the optimal consumption is x = 4 and y = 36

b. When price of x falls to Px2 = 4, we have that x = 9 and y = 36

c. How to find the decomposition basket?

1. Figure out the utility level of the original basket (4,36):

Since u(x,y)=xy, u(4,36)=4*36=144

2. The decomposition basket lies on an adjusted budget line with the new price ratio
Px2 /Py that is tangent to the original indifference curve.

The tangency condition: MRS= Px2 /Py , or y=4x

3. Solve for the decomposition bundle using 1 and 2:

xy = 144 and y=4x which implies that: x=6 and y=24
 Example 1
16

We have that:
-The original basket A is: (4,36)
-The final basket B is: (9,36)
Y: Composite good
-The decomposition basket C is: (6,24)

-When price of x decreases from 9 to

4, consumption of x increases by 5
units (from 4 to 9).
Substitution effect
- The substitution effect is 6-4=2.
- The income effect is 9-6=3.
A Income effect
•
C
• •B

x1 x2 X
 Example 2
17

Suppose the price of x is PX =2, the price of y is Py =4, and income is

I=12.
Y: Composite good For Daniel the goods are perfect substitutes: U=x+y

The price of y goes down to Py =1, what are the income and
B substitution effects?
12 •

Daniel

A
• X
6
 Example 3
18

Suppose the price of x is PX =2 and the price of y is Py =4, income I=12

For Isabel the goods are perfect complements: U=min{x,y}
Y: Composite good
The price of y goes down to Py =1, what are the income and
12 substitution effects?

Isabel

• B=(4,4)
3
•
A=(2,2)
X
6
 Example 4
19

Suppose that price of x is Px = 2 € and price of y is Py1 = 4 € and income I=24 €.

The utility function is U(x,y) = x1/2+y

a. What is the (initial) optimal consumption basket?

b. Suppose that price of y increases to Py2 = 8 €. What is the (final) optimal

consumption basket?

c. Find the decomposition basket. What is the substitution effect on y? What is

the income effect on y? What are the effects on x?

To check: A=(1, 5.5), B=(4, 2), D=(4, 4.5)

 Example 5: labor supply curve

Think of leisure (free time) as good x and all other products

(“consumption”) as good y. Let py=1, the hourly wage be w and assume the
Bob can work 24 hours per day if he wants to.

1. Draw the Bob’s daily budget line.

2. What happens to the budget line if w increases?
3. What is the “price” of leisure?
 Example 5: labor supply curve

Trade-off between leisure and consumption.

Wage as the price of leisure.
Budget line:
Consumption
I = (24 - L) w
where L = leisure hours and w = hourly wage

C
B •
A•
•

L1 L2 L3 L (hours of leisure)
 Example 5: labor supply curve
22

PL=w PL=w

Demand for leisure Supply of labour

w2 w2

w1 w1

0 0 24-L2 24-L1 24-L

L1 L2 L
 Example 5: labor supply curve

Think of leisure (free time) as good x and all other products (“consumption”,
c) as good y. Let pc=1, the hourly wage be w and assume the Bob can work
24 hours per day if he wants to. Let w1=10 and U(c,L)=(L-2)(c+12).

1. What is Bob’s initial optimal bundle?

2. Suppose that Bob’s wage doubles: w2=20. What is his new optimal
bundle?
3. Is his labour-supply curve everywhere upward-sloping?
4. (If you want and have a calculator: calculate the IE and SE of this wage
change. Answer: SE: 48 on c and -3.4 on L; IE: 62 on c and 3.1 on L.)
 Change in prices
24

Example of positive income effect (x is a normal good)

 Change in prices
25

Example of negative income effect (x is an inferior good)

 Change in prices
26

Definition:

A good is called a Giffen good if it is an inferior good and the effect of a price
decrease is a decrease in the consumption of a good. And a price increase leads
to an increase in consumption of a good. That is, demand does not slope
downwards.

This happens when the good is inferior and the income effect dominates the
substitution effect.
 Change in prices
27

Example Giffen good

 Consumer Surplus
28

Key Point:
Price
When the price is PX1 the consumer’s optimal bundle is X1 and
when she consumes X1 units, the most she is willing to pay for an
• additional unit of x is PX1 .

• Why?
P
 X1 •

P
 X2 •
•

P
 X3 •
•

0 X1 X2 X3
Quantity of x
 Consumer Surplus
29

Y: Composite good

•A
•B
•C

x1 x2 x3 X
I/PX3
I/PX1 I/PX2
 Consumer Surplus

Price Definition:
The consumer’s surplus is the net economic benefit to the
consumer from a purchase
 10 •
It is measured by the difference between the price that the
consumer is willing to pay and the price that she actually pays.
 7 •

 6 • The consumer’s surplus is the area between the market price and
the demand curve
5.5 •
5 •

2 •

0 1 2 3 4 5 10
Quantity
Consumer Surplus

Example
CS3 = .5(10-3)(28) = 98
CS2 = .5(10-2)(32) = 128
CSP = (10-P)(40-4P)/2
 Market Demand

Definition:
The market demand function is the horizontal sum of the individual
demands.

10 P P P

10 10
Q = 10 - P
Q = 20 – 5P
4 4 4

Q Q Q
Segment 1 Segment 2 Market demand