BUSINESS

ECONOMICS
Chapter 5: Consumer Demand

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READING
GLS – Chapter 5

Omissions:
§ Consumer responses to price changes: substitution and
income effects in Section 5.3
§ Appendix 5

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OUTLINE
Introduction
5.1 Income effects on consumers’ choices
5.2 Price effects on consumers’ choices
5.4 Cross-price effects on consumers’ choices
5.5 From individual to market demand

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EXAM PROBLEM (2023-ORDINARY)
A small remote island is inhabited by two consumers, Aage and
Birger. Aage’s demand for freshly brewed cappuccinos is given
by:
𝑄 ! = 10 − 𝑃
while Birger’s is given by

𝑄 " = 12 − 2𝑃

The price 𝑃 is taken for given.

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EXAM PROBLEM (2023-ORDINARY)
a) Find the choke prices for Aage’s and Birger’s individual
demand, respectively.
b) Derive the aggregate demand curve.

Yvonne moves to the island. Yvonne’s demand is given by

#
1
𝑄 =2− 𝑃
2

c) Derive the new aggregate demand curve.

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EXAM PROBLEM (2023-ORDINARY)
On a different island, Ø2, demand is given by
𝑄 $ = 20 − 4𝑃
while the supply is given by

𝑄 % = 2𝑃 − 4

d) Find the equilibrium price and quantity on Ø2.

e) Calculate the consumer surplus (CS), producer surplus (PS),
and total surplus on Ø2. Illustrate the situation in a diagram.

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OUTLINE
Introduction
5.1 Income effects on consumers’ choices
5.2 Price effects on consumers’ choices
5.4 Cross-price effects on consumers’ choices
5.5 From individual to market demand

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INTRODUCTION
In the last chapter, we studied optimal consumer choice.

Next, we analyze the effects of income and prices on consumer

choice.

The relationship between optimal consumer choice (i.e., quantity

demanded) and price is the individual demand function

We analyze some properties of demand.

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OUTLINE
Introduction
5.1 Income effects on consumers’ choices
5.2 Price effects on consumers’ choices
5.4 Cross-price effects on consumers’ choices
5.5 From individual to market demand

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INCOME EFFECTS
Income effect: Change in a consumer’s consumption choices that
results from a change in the consumer’s income (all else equal)

Two cases:
• Normal goods: higher income is associated with rising
consumption
• Inferior goods: higher income is associated with falling
consumption

Note: A good can be normal at lower values of income, but inferior

at higher values of income.

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INCOME EFFECTS
} Income elasticity of demand is percentage change in quantity
consumed associated with percentage change in income (i.e.,
budget):
%∆%! &%! !
𝐸!" = %∆!
= &!
# %!
where 𝜕𝑄 $ /𝜕𝐼 is income effect.
} Sign of income effect determines sign of income elasticity:
𝐸&$ > 0 for normal good, and 𝐸&$ < 0 for inferior good.
} Classification of normal goods into two sub-types:
necessity goods (0 < 𝐸&$ < 1), and luxury goods (𝐸&$ > 1)

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INCOME EFFECTS
Number of
Antioxidant
For normal goods, higher drinks

8
income gives more
7
consumption.
6
For example, Steve consumes
5
antioxidant drinks and nutrition bars.
4
When his budget doubles, he buys 3

more of both goods. C1

2

1
𝑼𝟏

0 1 2 3 4 Number
of Nutrition
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INCOME EFFECTS
Number of
Antioxidant
For normal goods, higher drinks
Budget constraint
8
income gives more for higher budget
7
consumption.
6
For example, Steve consumes
5
antioxidant drinks and nutrition bars.
4
When his budget doubles, he buys 3

more of both goods. C1

2

1
𝑼𝟏

0 1 2 3 4 Number
of Nutrition
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INCOME EFFECTS
Number of
Antioxidant
For normal goods, higher drinks
Budget constraint
8
income gives more for higher budget
7
consumption.
6
For example, Steve consumes
5
antioxidant drinks and nutrition bars. C2
4
When his budget doubles, he buys 3

more of both goods. C1 𝑼𝟐

2

1
𝑼𝟏

0 1 2 3 4 Number
of Nutrition
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INCOME EFFECTS
Quantity
But for inferior good, of spam
higher income gives less 8
consumption.
7
For example, tin of spam 6
vs fresh steak.
5

4
C1
3

2
𝑼𝟏
1

0 1 2 3 4 Quantity
of steak
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INCOME EFFECTS
Quantity
But for inferior good, of spam
Budget constraint
higher income gives less 8
for higher budget
consumption.
7
For example, tin of spam 6
vs fresh steak.
5

4
C1
3

2
𝑼𝟏
1

0 1 2 3 4 Quantity
of steak
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INCOME EFFECTS
Quantity
But for inferior good, of spam
Budget constraint
higher income gives less 8
for higher budget
consumption.
7
For example, tin of spam 6
vs fresh steak.
5

4
C1
3
C2
2
𝑼𝟏
𝑼𝟐
1

0 1 2 3 4 Quantity
of steak
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OUTLINE
Introduction
5.1 Income effects on consumers’ choices
5.2 Price effects on consumers’ choices
5.4 Cross-price effects on consumers’ choices
5.5 From individual to market demand

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PRICE EFFECTS
Steve’s utility function for choice between number of antioxidant
drinks (𝐴), and number of nutrition bars (𝑁):
𝑈(𝐴, 𝑁) = 𝐴𝑁
Steve’s budget constraint: Assume:
𝐵 = 𝑃( 𝐴 + 𝑃) 𝑁 ⟺ 𝐴 = + − +# 𝑁.
* + 𝐵 = 80
" " 𝑃! = 20
Steve’s optimality condition:
𝑃" = 40
,-# +# +#
,-"
= +"
⇒𝐴= +"
𝑁.
* *
Steve’s optimal choice: 𝑁, 𝐴 = ,
.+# .+"
.

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PRICE EFFECTS
} Reducing nutrition bar price, Number of
Antioxidant
𝑃0 , rotates Steve’s budget drinks
Assume:
𝐵 = 80
constraint outwards 𝑃! = 20
4 𝑃0 = 40
} Nutrition bar prices 𝑃0 = 40,
𝑃0 = 20, and 𝑃0 = 10 give 3

optimal bundles C1, C2, 2

and C3, respectively. 1

} Outward rotation increases

0 1 2 3 4
Number
optimal number of nutrition of Nutrition
bars
bars

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PRICE EFFECTS
} Reducing nutrition bar price, Number of
Antioxidant
𝑃0 , rotates Steve’s budget drinks Assume:
constraint outwards 𝐵 = 80
𝑃! = 20
4
} Nutrition bar prices 𝑃0 = 40, 𝑃0 = 40

𝑃0 = 20, and 𝑃0 = 10 give 3

C1
optimal bundles C1, C2, 2

and C3, respectively. 1

𝒖= 𝟐
} Outward rotation increases
0 1 2 3 4
Number
optimal number of nutrition of Nutrition
bars
bars

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PRICE EFFECTS
} Reducing nutrition bar price, Number of
Antioxidant
𝑃0 , rotates Steve’s budget drinks
Assume:
𝐵 = 80
constraint outwards 𝑃! = 20
4 𝑷𝑵 = 𝟐𝟎
} Nutrition bar prices 𝑃0 = 40,
𝑃0 = 20, and 𝑃0 = 10 give 3
C1
optimal bundles C1, C2, 2

and C3, respectively. 1

𝒖= 𝟐
} Outward rotation increases
0 1 2 3 4
Number
optimal number of nutrition of Nutrition
bars
bars

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PRICE EFFECTS
} Reducing nutrition bar price, Number of
Antioxidant
𝑃0 , rotates Steve’s budget drinks
Assume:
𝐵 = 80
constraint outwards 𝑃! = 20
4 𝑷𝑵 = 𝟐𝟎
} Nutrition bar prices 𝑃0 = 40,
𝑃0 = 20, and 𝑃0 = 10 give 3
C1 C2
optimal bundles C1, C2, 2

and C3, respectively. 1 𝒖=𝟐

𝒖= 𝟐
} Outward rotation increases
0 1 2 3 4
Number
optimal number of nutrition of Nutrition
bars
bars

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PRICE EFFECTS
} Reducing nutrition bar price, Number of
Antioxidant
𝑃0 , rotates Steve’s budget drinks Assume:
𝐵 = 80
constraint outwards 𝑃! = 20
4 𝑷𝑵 = 𝟏𝟎
} Nutrition bar prices 𝑃0 = 40,
𝑃0 = 20, and 𝑃0 = 10 give 3
C1 C2
optimal bundles C1, C2, 2

and C3, respectively. 1 𝒖=𝟐

𝒖= 𝟐
} Outward rotation increases
0 1 2 3 4
Number
optimal number of nutrition of Nutrition
bars
bars

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PRICE EFFECTS
} Reducing nutrition bar price, Number of
Antioxidant
𝑃0 , rotates Steve’s budget drinks
Assume:
𝐵 = 80
constraint outwards 𝑃! = 20
4 𝑷𝑵 = 𝟏𝟎
} Nutrition bar prices 𝑃0 = 40,
𝑷𝑵 = 𝟏𝟎
𝑃0 = 20, and 𝑃0 = 10 give 3
C1 C2 C3
optimal bundles C1, C2, 2
𝒖=𝟐 𝟐
and C3, respectively. 1 𝒖=𝟐
𝒖= 𝟐
} Outward rotation increases
0 1 2 3 4
Number
optimal number of nutrition of Nutrition
bars
bars

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PRICE EFFECTS
Number of
Antioxidant
drinks

} Nutrition bar prices 𝑃0 = 40,

3
𝑃0 = 20, and 𝑃0 = 10 give C1 C2 C3
2
optimal bundles C1, C2, and
1
C3, respectively.

} Price reduction gives increase 0 1 2 3 4 Number

𝑷𝑵 of Nutrition
bars
in optimal number of nutrition
40 Demand for
bars: downward-sloping nutrition bars
30
demand curve 20

10 𝒒𝑫
𝑵 (𝑷𝑵 )

1 2 3 4 5 Number
of Nutrition
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PRICE EFFECTS
Number of
Antioxidant
drinks

} Steve gets stronger preference D2 D3

3
for antioxidant drinks: D1
2
𝑈 = 𝑁 3/5 𝐴6/5 . C1 C2 C3
1
} Nutrition bar prices 𝑃0 = 40,
𝑃0 = 20, and 𝑃0 = 10 give 0 1 2 3 4 Number
𝑷𝑵 of Nutrition
bars
optimal bundles D1, D2, New demand for
40 nutrition bars
and D3, respectively.
30
Old demand for
nutrition bars
} Preference change reduces 20

demand for nutrition bars… 10 𝒒𝑫

𝑵 (𝑷𝑵 )
𝒒𝑫
𝑵 (𝑷𝑵 )
1 2 3 4 5 Number
of Nutrition
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PRICE EFFECT - DECOMPOSITION
Nutrition bar price reduction leaves Steve’s consumption of
antioxidant drinks unchanged. This results from special feature of
Cobb-Douglas utility function, and trade-off between two generic
effects:
} Antioxidant drink becomes relatively more expensive, nutrition
bar relatively less. Steve likes to substitute antioxidant drinks for
nutrition bars (substitution effect)
} Steve’s total purchasing power of income increases, and he can
afford to buy more antioxidant drinks (income effect)

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OUTLINE
Introduction
5.1 Income effects on consumers’ choices
5.2 Price effects on consumers’ choices
5.4 Cross-price effects on consumers’ choices
5.5 From individual to market demand

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CROSS-PRICE EFFECTS
Substitutes and complements
When the price of a substitute good increases, we expect
consumption of the primary good to increase.
• Consider Pepsi and Coke

When the price of a complement increases, we expect

consumption of the primary good to decrease.
• Consider tomatoes and mozzarella balls

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CROSS-PRICE EFFECTS
If price of substitute good rises, we expect increased
consumption of primary good. Pepsi

} At original (equal) prices, 20

A
consumer buys 4 bottles of 16
U1
Coke and 16 bottles of Pepsi 12

} Doubling Pepsi price gives

8 BC2 U2 BC1
rise of Coke consumption B
4
(12 bottles), and fall of Pepsi
0
4 8 12 16 20 Coke
consumption (4).

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CROSS-PRICE EFFECTS
If price of complementary good
rises, we expect reduced Mozzarella
balls
consumption of primary good.
10 BC1
} At original prices (1:1), con-
8
U
sumer buys 4 mozzarella balls 1
6 U2
and 6 tomatoes BC2
A
4 B
} Doubling mozzarella price
2
yields fall of tomato consumption
(to 4 pieces) and mozzarella 0
2 4 6 8 10
Tomatoes
consumption (3 balls).

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CROSS-PRICE EFFECTS
Cross price effects on optimal
Price of
consumption choice help to
good X
explain demand shifts (Ch. 2)

} Outward demand shift if

price of substitute rises or
price of complement falls.

} Inward demand shift if

price of substitute falls or 𝑫𝟑 𝑫𝟐
𝑫𝟏
price of complement rises. Quantity
of good X

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OUTLINE
Introduction
5.1 Income effects on consumers’ choices
5.2 Price effects on consumers’ choices
5.4 Cross-price effects on consumers’ choices
5.5 From individual to market demand

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FROM INDIVIDUAL TO MARKET DEMAND
The final step linking consumer theory to market demand:

• Market demand is the horizontal sum of individual demand

curves.

• The market quantity demanded at each price is the sum of the

individual quantities demanded at each price.

The market demand curve is found by summing horizontally the

individual demand curves.

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FROM INDIVIDUAL TO MARKET DEMAND

Buyer 𝑖 chooses individual demand function: 𝑞:$ (𝑝) for 𝑖 = 1,2.

Market demand sums individual demands at each price

(i.e., horizontally): 𝑄 $ 𝑃 = 𝑞3$ (𝑃) + 𝑞;$ (𝑃).

𝑃 𝑃 𝑃

10

5
𝒒𝑫
𝟏 (𝑷) 𝒒𝑫
𝟐 (𝑷) 𝑸𝑫 𝑷

𝑞# 𝑞& 0
12 24 12 12 24 36 𝑞3 + 𝑞;

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SUMMARY: DEMAND
} Income effect: consumption of good increases in disposable
income for normal goods, but it decreases for inferior goods

} Change of good’s price rotates budget constraint, and changes

optimal choice of this good: consumer’s demand function.

} Increasing other good’s price increases (reduces) demand for

substitutes (complements)

} Market demand function is sum of individual demand functions

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READING AND OUTLOOK
Reading from GLS: Chapter 5 with exception of:
§ Consumer responses to price changes: substitution and
income effects in Section 5.3
§ Appendix 5

} Next: Producer behavior

● Basics of production (6.1)

● Production in short and long run (6.2-6.3)

● Cost-minimization problem (6.4)

● Returns to scale (6.5)

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IN ST IT U T FO R Ø KO N O M I
AA R H U S U N IV ER SITET