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 LECTURE 4
THE CONSUMER THEORY 2
INDIVIDUAL AND MARKET
DEMAND

Module: 4ECON005C Module Leader:

Exploring Economics Zohid Askarov

Semester 1
 Individual and Market Demand

Analysis of demand
1.Deriving of the demand curve
2.Looking at the effect of a price and income
change
3.Studying the characteristics of market demand
4.Consumer expenditures in the United States
(example)
5.Lagrange multiplier
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Individual Demand
EFFECT OF PRICE CHANGES
A reduction in the price of food, with income
and the price of clothing fixed, causes the
consumer to choose a different market
basket.
In panel (a), the baskets that maximize utility
for various prices of food (point A, $2; B, $1;
D, $0.50) trace out the price-consumption
curve.
Part (b) gives the demand curve, which
relates the price of food to the quantity
demanded.
(Points E, G, and H correspond to points A,
B, and D, respectively).
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Individual Demand
The Individual Demand Curve
price-consumption curve Curve tracing the utility-maximizing
combinations of two goods as the price of one changes.
individual demand curve Curve relating the quantity of a good that a
single consumer will buy to its price.
The individual demand curve has two important properties:
1. The level of utility that can be attained changes as we move along the
curve.
2. At every point on the demand curve, the consumer is maximizing utility
by satisfying the condition that the marginal rate of substitution (MRS) of
food for clothing equals the ratio of the prices of food and clothing.

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 Individual Demand
EFFECT OF INCOME CHANGES
In part (a), the baskets that maximize
consumer satisfaction for various incomes
(point A, $10; B, $20; D, $30) trace out the
income-consumption curve.
The shift to the right of the demand curve in
response to the increases in income is
shown in part (b). (Points E, G, and H
correspond to points A, B, and D,
respectively.)
income-consumption curve Curve tracing
the utility-maximizing combinations of two
goods as a consumer’s income changes.

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Normal versus Inferior Goods

AN INFERIOR GOOD
An increase in a person’s
income can lead to less
consumption of one of the two
goods being purchased.
Here, hamburger, though a
normal good between A and
B, becomes an inferior good
when the income-consumption
curve bends backward
between B and C.

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 Engel Curves
FIGURE 4.4

ENGLE CURVES
Engel curves relate the quantity of a
good consumed to income.
In (a), food is a normal good and the
Engel curve is upward sloping.
In (b), however, hamburger is a
normal good for income less than
$20 per month and an inferior good
for income greater than $20 per
month.
Engel curve Curve relating the
quantity of a good consumed to
income.
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 Income and Substitution Effects

A fall in the price of a good has two effects:

1. Consumers will tend to buy more of the good that has become cheaper
and less of those goods that are now relatively more expensive. This
response to a change in the relative prices of goods is called the
substitution effect.
2. Because one of the goods is now cheaper, consumers enjoy an increase
in real purchasing power. The change in demand resulting from this
change in real purchasing power is called the income effect.

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 Income Effects

Food:
Scenario 1: Price change.
Income: 20,000 soums Price 10,000 soums Units purchased: 2
Income: 20,000 soums Price 5,000 soums Units purchased: 4

Scenario 2: Income change.

Income: 20,000 soums Price 10,000 soums Units purchased: 2
Income: 40,000 soums Price 10,000 soums Units purchased: 4

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 Income and Substitution Effects
Substitution effect Change in consumption of a good associated with a change in
its price, with the level of utility held constant.

Income effect Change in consumption of a good resulting from an increase in

purchasing power, with relative prices held constant.
In Figure 4.6, the total effect of a change in price is given theoretically by the sum of
the substitution effect and the income effect:

Total Effect (F 1F 2)  Substitution Effect (F 1E )  Income Effect (EF 2)

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From previous week lecture: Indifference Curves and MRS

THE MARGINAL RATE OF

SUBSTITUTION
The magnitude of the slope of an
indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two
goods.
In this figure, the MRS between
clothing (C) and food (F) falls from 6
(between A and B) to 4 (between B
and D) to 2 (between D and E) to 1
(between E and G).

MRS  - (ΔC /ΔF )

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 Income and Substitution Effects

FIGURE 4.6

INCOME AND SUBSTITUTION EFFECTS: NORMAL

GOOD
A decrease in the price of food has both an income
effect and a substitution effect.
The consumer is initially at A, on budget line RS.
When the price of food falls, consumption increases by
F1F2 as the consumer moves to B.
The substitution effect F1E (associated with a move from
A to D) changes the relative prices of food and clothing
but keeps real income (satisfaction) constant.
The income effect EF2 (associated with a move from D
to B) keeps relative prices constant but increases
purchasing power.
Food is a normal good because the income effect EF2 is
positive.
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 Market Demand
market demand curve Curve relating the quantity of a good that all
consumers in a market will buy to its price.
From Individual to Market Demand

TABLE 4.2: DETERMINING THE MARKET DEMAND CURVE

(4)
(2) (3) INDIVIDUAL (5)
(1) INDIVIDUAL A INDIVIDUAL B C MARKET
PRICE ($) (UNITS) (UNITS) (UNITS) UNITS
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
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 Market Demand
FIGURE 4.10

SUMMING TO OBTAIN A MARKET DEMAND CURVE

The market demand curve is obtained by

summing our three consumers’ demand
curves DA, DB, and DC.
At each price, the quantity of coffee
demanded by the market is the sum of the
quantities demanded by each consumer.
At a price of $4, for example, the quantity
demanded by the market (11 units) is the sum
of the quantity demanded by A (no units), B (4
units), and C (7 units).

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Demand Theory—A Mathematical Treatment
• LAGRANGE MULTIPLIER

Using a Lagrangian to solve a budget constrained

optimization problem:
L = objective function + λ(constraint),
where λ is the Lagrange multiplier

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Lagrange Multiplier
• Example: Consider a consumer with a simple utility function given by:
u = FC + 2F
• Assume that the price of food is $4 per unit, the price of clothing is $2 per
unit, and monthly income of the consumer is $60.
• Determine the F,C combination which maximizes the consumer’s utility.
• Solution:
• Objective function: u = FC + 2F
• Constraint: 60 = 4F + 2C, re-arrange as 60 - 4F - 2C =0;
L = (FC + 2F) + λ(60 - 4F - 2C);
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Lagrange Multiplier

L = (FC + 2F) + λ (60 - 4F - 2C);

𝝏𝑳 𝝏𝑳 𝝏𝑳
= 𝑪 + 𝟐 − 𝟒λ; = 𝑭 − 𝟐λ; = 𝟔𝟎 − 𝟒𝑭 − 𝟐𝑪;
𝝏𝑭 𝝏𝑪 𝝏λ

C + 2 - 4λ = 0 finding C, F and imputing the into the last expression gives:

F - 2λ = 0 λ =4; C =14; F=8

4F + 2C = 60

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Suggested Reading
• For this lecture
• Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 4. Appendix 4.

Alternatively
• Perloff, J.M. "Microeconomics", 5th edition, Chapter 4
• Rittenberg & Tregarthen (2009). "Principles of Microeconomics". Chapter 7
• Or, any Microeconomics textbook, sections on preferences, utility and budget constraints

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