Topic 1: Lecture 6

1
Topic 1 Lecture 6
Demand Analysis Change in price of X
Y
Ymax
What can you say about the demand for X as Px??
Y
a
X
0
X
Xmax
2
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 1)
IC1
IC2
Y
Ymax
What can you say about the demand for X as Px??
â
Y
a
X
0
X
Xmax
3
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 1)
What is the implication for the shape of the
demand curve for X in (Px, X)space? What is
held constant along this demand curve?
IC1
IC2
Y
Ymax
â
Y
a
X
0
X
Xmax
4
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 2)
What is the implication for the shape of the
demand curve for X in (Px, X)space? What is
held constant along this demand curve?
IC1
Y
Ymax
IC2
Y
a
â
X
0
X
Xmax
5
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 2)
IC1
Y
Ymax
What is the relationship between the price of X,
its demand, and the demand for Y?
IC2
Y
a
â
X
0
X
Xmax
6
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3)
IC1
Y
IC2
Ymax
What is the implication for the shape of the
demand curve for X in (Px, X)space?
â
Y
a
X
0
X
Xmax
7
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3)
IC1
Y
IC2
Ymax
What is the relationship between the price of X,
its demand, and the demand for Y?
â
Y
a
X
0
X
Xmax
8
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 4)
IC1
IC2
Y
Ymax
What is the implication for the shape of the
demand curve for X in (Px, X)space?
â
Y
a
X
0
X
Xmax
9
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)

• There are 2 reasons for the rise in demand for X
  following the fall in its price
• Disposable (or real) Income Effect
• Relative Price Effect

Y
Ymax
â
Y
a
X
0
X
Xmax
10
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)

• There are 2 reasons for the rise in demand for X
  following the fall in its price
• Disposable (or real) Income Effect
• The budget constraint shifts outwards and hence
  the individual can achieve higher utility that
  is, move on to previously unobtainable
  Indifference Curves. They are able to buy more of
  both X and Y whether or not they do so will
  depend on their preferences over X and Y. If X is
  normal, for example, the Real Income Effect will
  cause the individual to buy more X.
• Relative Price Effect
• X is now relatively cheaper than previously
  relative to Y. The individual is therefore likely
  to switch from Y towards X, to some extent.

11
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)

• We would now like to be able to distinguish
  between these two effects in the diagram.
• Real Income Effect
• Relative Price Effect

Y
Ymax
â
Y
a
X
0
X
Xmax
12
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)
Consider first the Relative Price
Effect. Suppose relative prices had changed, but
that there had been no Real Income Effect of the
price change. What point in the diagram could
represent such a position?
Y
Ymax
â
Y
a
X
0
X
Xmax
13
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)
Consider first the Relative Price
Effect. Suppose relative prices had changed, but
that there had been no Real Income Effect of the
price change. What point in the diagram could
represent such a position? b
Y
Ymax
â
Y
a
b
X
0
X
Xmax
14
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)
Relative Price Effect. What change is causing
the consumer equilibrium to move from a to
b? What is not changing between a and
b? Hence, a to b represents a pure
relative price effect.
Y
Ymax
â
Y
a
b
As a and b lie on the same IC, there is no
Real Income change in moving from a to b.
X
0
X
Xmax
15
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)
Relative Price Effect. a to b represents a
pure relative price effect. More commonly, we
refer to it as a substitution effect
Y
Ymax
â
Y
a
b
S
X
0
X
Xs
Xmax
16
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)
Real Income Effect. We claimed that the Total
Effect of the price change (i.e., from a to
â) is made up of a Relative Price
(Substitution) Effect and a Real Income Effect.
Y
Ymax
â
Y
a
b
As a to b is the substitution effect, can we
show that b to â is the Real Income Effect?
S
X
0
X
Xs
Xmax
17
Topic 1 Lecture 6
Demand Analysis Change in price of X (CASE 3
Revisited)
Real Income Effect. Compare b and â. What
have they got in common? What is different
between them? Your answers should confirm for you
that b to â captures the Real Income Effect.
Y
Ymax
â
Y
a
b
As a to b is the substitution effect, can we
show that b to â is the Real Income Effect?
S
I
X
0
X
Xs
X
18
Topic 1 Lecture 6
Now read BB 4th Ed., pp. 151-171 (but dont
worry about issues (especially the mathematical
material) which go beyond what you have seen in
lecture notes or seminar exercise sheets)