Demand Curves

The consumer’s utility maximization is given by:

max U (x; y)
x;y

subject to
px x + py y = I:

The optimal solution (x ; y ) is a function of the exogenous variables px ; py ; and I :

x = d(px ; py ; I)

y = d(px ; py ; I)

The function x = d(px ; py ; I) is commonly known as the demand curve for x.

Similarly, the function y = d(px ; py ; I) is known as the demand curve for y.

The determinants of the demand of x are px ; py ; and I: The determinants of the

demand of y are px ; py ; and I:

Example: Let
U (x; y) = xa y b :

The demand curves are given by:

aI
x = = d(px ; I)
px
bI
y = = d(py ; I)
py

For this utility function, the demand x is a function of px and I only. Similarly,
the demand y is a function of py and I only.

56
 From the commodity space (x and y) to the price-quantity space (px and x):

From Indi¤erence Curves to Demand Curves

y As the price px
6 of x falls... 6

...quantity of x

t
demanded rises.
Ll
\ p0x
l
L\ l
L \ l
L \ l p00x t
L \ l
L \ l t
Lt \ l p000
\t t
x
L l D
l
L \ l
L \ l
L \ l
l U3
L \ U2 l
L \ U1 l
LL COC\
\ BM l - -
x1 x2 x3 C B x x1 x2 x3
C B x
C B
C B
p0x x + py y = I p00x x + py y = I p000
x x + py y = I

The conventional curve px = f (x; py ; I) is actually the inverse demand curve.

Alfred Marshall (1890, 1920): "To obtain complete knowledge of demand for any-
thing, we should have to ascertain how much of it he would be willing to purchase
at each of the prices at which it is likely to be o¤ered; and the circumstance of his
demand for, say, tea can be best expressed by a list of the prices which he is willing
to pay; that is, by his several demand prices for di¤erent amounts of it. (This list
may be called his demand schedule.) ... Such a demand schedule may be translated,
on a plan now coming into familiar use, into a curve that may be called his demand
curve. Let Ox and Oy be drawn the one horizontally, the other vertically. Let an
inch measured along Ox represent 10 lbs. of tea, and an inch measured along Oy
represent 40d." (d = penny)

57
Properties of Demand
1. Homogeneity
tx?
d(tpx ; tpy ; tI) = (23)
x?

If prices and income are doubled, will the quantity demanded be doubled or the
same?

r
A function is homogeneous of degree r if f ( x) = f (x):

Examples:
p
1. f (x; y) = xy

2. f (x; y) = xa y b

3. f (x; y) = xa + y b

Demand curves are homogeneous of degree ___.

Example: Cobb-Douglas utility

58
2. Movements along the demand curve versus shifts in the de-
mand curve
Demand curve x = d(px ; py ; I)

Movements along the demand curve: e.g., a change (decrease/increase) in the

quantity demanded for x due to a change in px :

aI @x aI
For the Cobb-Douglas utility function u(x; y) = xa y b , x = px
; hence @px
= p2x
:

– True/False/Uncertain: The demand for x would fall if the price of x went up.

Shifts in the demand curve: e.g., a change (decrease/increase) in the demand for x
due to a change in py or I:

aI @x a
For the Cobb-Douglas utility function u(x; y) = xa y b , x = px
; hence @I
= px
:

– True/False/Uncertain: The quantity demanded for x would increase if income

I went up.
– True/False/Uncertain: The quantity demanded for x would fall if the price of
y went up.
– @p@I
xx
=? What is the interpretation of @px x
@I
?

Although mathematically @x @px

and @x
@I
are both partial derivatives, why do we need
di¤erent terminologies for the changes?

3. Price elasticity of demand

Measure the sensitivity (elasticity) of the quantity demanded to changes in price.

Own Price Elasticity of Demand = ex;px = pxx @p

@x
x
: Note that there is no minus sign
in the de…nition (however, some textbooks adopt the de…nition pxx @p @x
x
):

@x
px @x @ ln x x percentage in x
ex;px = = = @px
=
x @px @ ln px px
percentage in px

Examples

1. Linear demand curve: x = a bpx : What is ex;px ?

aI
2. Demand curve from a Cobb-Douglas utility: x = px
: What is ex;px ?

59
 3. What demand curves have a constant price elasticity of demand (isoelastic demand
curves)?

How do we de…ne inelastic/unit-elastic/elastic demand?

8
< inelastic if jex;px j < 1
The demand is price unit-elastic (unitary-elastic) if jex;px j = 1
:
elastic if jex;px j > 1

Two useful formulas on the price elasticity of demand:

@px x @x px @x
= x + px =x 1+ = x (1 + ex;px )
@px @px x @px
!
@px x @px 1 1
= px + x = px 1 + px @x = px 1 +
@x @x x @px
ex;px
It follows that
> >
@px x
= 0 if and only if ex;px = 1
@px
< <
> <
@px x
= 0 if and only if ex;px = 1
@x
< >

4. Downward sloping
@x
A demand curve is downward sloping if < 0:
@px

De…nition

– Gi¤en Good: @x=@px > 0

– Normal Good: @x=@I > 0
– Inferior Good: @x=@I < 0

60
What is the income consumption curve for a normal good? An inferior good?

Income-consumption curve ABC (x is a normal good)

y 6

Z
Z
Z
Z
Z Z
Z Z
Z Z
Z Z
Z Z Z
Z Z Z
Z Z Z
Z uC
Z Z Z
Z Z
Z ZB ZZ
Z u
Z Z
Z Z
Zu
Z Z Z
Z Z
Z Z
A ZZ Z Z U3
Z Z Z
Z Z Z U2
Z Z Z
Z Z Z
Z Z Z U
Z Z Z 1
Z Z Z
Z Z Z
Z
Z Z
Z ZZ - x

Income-consumption curve ABC (x is an inferior good)

y 6

Z
Z
Z
Z
Z Z
Z Z
Z Z uC
Z Z
Z Z Z
Z Z Z
Z Z Z
u
Z Z Z
Z Z B Z U3
Z Z Z
Z Z Z
Z Z Z
Zu
Z A Z Z
Z Z
Z Z Z
Z Z Z
Z Z Z U2
Z Z Z
Z Z Z
Z Z Z
Z Z Z U
Z Z Z 1
Z Z Z
Z Z Z
ZZ Z
Z Z
Z - x

61
 A Gi¤en good has an upward sloping demand curve. There is no empirical evidence
of a Gi¤en good so far.

?
)
Normal good demand curve is downward sloping
(
?

(i) Substitution E¤ect and Income E¤ect

The e¤ect of a change in px on x can be decomposed into two e¤ects: substitution e¤ect
and income e¤ect. For example, a decrease in px will reduce the relative price of x and
raise the real income (purchasing power).

The distinction between substitution and income e¤ects is one of the most subtle
concepts in microeconomics. First, these two e¤ects are unobservable, only their
combined e¤ect (total e¤ect) is observable. Separating the combined e¤ect into two
separate e¤ects is an arti…cial analytical tool, but it is useful. Second, the income
e¤ect occurs even when nominal income is unchanged.

The total e¤ect is observable. The substitution and income e¤ects are hypothetical
(imaginary) constructs. The decomposition o¤ers a way to analyze the total e¤ect.
There are di¤erent ways to decompose the total e¤ect (hence di¤erent measures
of the substitution and income e¤ects). The most popular way is to hold utility
constant.

62
Substitution E¤ect = the change in x due to a change in px ; holding utility constant

– Intution: Suppose there are many goods, each of which takes up only a small
percentage of income. The decrease in px has a negligible e¤ect on the real
income (thus the income e¤ect is negligble). The increase in the quantity
demanded of x comes solely from substitution.

Income E¤ect = the change in x due to a change in I (income), holding relative

prices (px =py ) constant.

– Intuition: Suppose there is only one good. In this case, there is no substitution
e¤ect. The decrease in px will raise the real income (as there is no change in
the nominal income), hence the quantity demanded of x will go up.

The E¤ect of a Decrease in px on x

y Suppose the consumer is maximizing

utility at point A.
6

Z
JZ
J Z If the price of good x falls, the consumer
J Z will maximize utility at point B.
J ZZ
J Z
J Z
J Z
J Z
Z
Z u
J
B
Z
Ju
J
Z
Z
J Z
A J Z
J Z
Z
J Z
J Z U2
J Z
Z
J Z
J Z U
J Z 1
- J Z
Z
J
J ZZ - x
Total increase in x

63
 Substitution E¤ect

y To isolate substitution e¤ect, we hold

"real" income constant but allow the rela-
6 tive price of good x change
Z
JZ
J Z The substitution e¤ect is the movement from
J Z point A to point C
J ZZ
J Z
J Z
qq
J Z
qq
Z The individual substitutes
qq
J Z
qq J
good x for good y be-
qq J
Z
qq u
Z
q qJ
cause it is now rela-
A q qJq q q
Z
Z tively cheaper
Jq q q C
Z
J quq q q
Z
Z
J qqq
Z
q qq
Z
qq
Z
qq
J Z
q q
J
qq
Z
q qq
J Z
qq
Z U
qq
J Z 1
q qq
J Z
- J Z
J
J ZZ - x
Substitution e¤ect

Income E¤ect
(assuming x is a normal good)
y
The income e¤ect occurs because the
6 individual’s "real" income changes when
the price of good x changes
Z
JZ
J Z
J Z The income e¤ect is the movement from
J ZZ point C to point B
J Z
J Z
qq
J Z
qq
Z
qq
J If x is a normal good, the
Z
qq J
qq J Z uB
Z individual will buy more
qq u
q qJ
qq
Z because "real" income
A Jq qJq q C
Z increased.
Z
qqu
J qqqq
Z
Z
q qq
Z
q
U2
qq
J Z
qq
Z
qq
J
q
Z
qq
J Z
qq
qq
J Z
qq
Z U
qq
J
q
Z 1
q
J
q
Z
-J Z
ZZ
J
J - x

Income e¤ect
64
 Total E¤ect = Substitution E¤ect + Income E¤ect
(assuming x is a normal good)
y
The income e¤ect occurs because the
6 individual’s "real" income changes when
the price of good x changes
Z
J
JZZ The substitution e¤ect (S.E.) is the
J Z
J Z movement from point A to point C
J Z
Z
J Z
qq
J Z
qq
Z
qq
J The income e¤ect (I.E.) is the
Z
qq
qq J Z uB
J Z movement from point C to
qq u
q qJ
qq
Z point B (x is a normal good)
A Jq qJq q C
Z
Z
qqu
J qqqq
Z
Z
J qqq
Z
q
U2
qq
Z
qq
Z
qq
J
q
Z
q
J
qq
Z
q qq
J Z
qq
Z U
qq
J
q
Z 1
qq
J Z
- J Z
- ZZ
J
J - x
S.E. I.E.

The Impact of an Increase in px on x

(assuming x is a normal good)
y
6
An increase in the price of good x means that
qq
qq
the budget constraint gets steeper
qq
qq
Z
J
qq
Z
qq
J Z
qq
J Z The substitution e¤ect is the
J Z q qq
q
Z movement from point A to point C
qq
J Z
qvq
J Z C
Z qq
J Z
Z qq
Zq q q
J
Zq q
J The income e¤ect is the
qq v
J A
Jv q qZ
Z movement from point C
qq Z
qq Z
J to point B
B J qq Z
qq
qq
J Z
q qq
J Z U1
q
J Z
qq
Z
qq
J Z
J qq Z
qq Z
qq
J Z
q
J Z U2
J Z
J Z
Z
JJ Z
Z - x
Substitution E¤ect
Income E¤ect 65
 x is an inferior good but not a Gi¤en good
@x=@px < 0
y

Z
JZ
J Z
J Z
J ZZ
J B
Z u
Z
J
qq
J Z
qq
Z
qq
J Z
qq J
qq J
Z
qq u
Z
q qJ
qq
Z
A Jq qJq q C
Z U2
Z
qq
J quq q q
Z
Z
q qq
Z
q qq
J Z
qq
Z
q
J
qq
Z
q
J
qq
Z
qq
J Z
qq
qq
J Z U1
qq
Z
qq
I.E . J Z
- J Z
J
J ZZ - x
S.E.

x is a Gi¤en good
@x=@px > 0
y

Z
JZ
J Z
J ZuZ
J Z B
J Z
J Z
qq
J Z
qq
Z U2
qq
J Z
q q J uA
qq J
Z
qq
Z
q qJ
qq
Z
Jq q
Z
Jq q q q
Z
J qqqq C
Z
Z
u
q qq
Z
q qq
J Z
qq
Z
qq
J
q
Z
qq
J Z
qq
qq
J Z
qq
Z
q
J
qq
Z
q
J
q
I.E. U1 Z
- J Z
J
J ZZ - x
S.E.
66
Terminology
price-consumption curve (price-consumption path): The curve that traces the utility-
maximizing combinations of two goods as the price of one of the goods changes.

income-consumption curve (income-consumption path, income-expansion curve, income-

expansion path): The curve that traces the utility-maximizing combinations of two
goods as the consumer’s income changes.

Engel curve: The curve that relates the quantity of a good consumed to income.

Confusing de…nitions:
De…nition I De…nition II
> 0; then x is a Gi¤en good > 0; then x is a Gi¤en good
@x @x
If @px = 0; If @px = 0;
< 0; no speci…c name for the good < 0; then x is a normal good
> 0; then x is a normal good > 0; then x is a superior good
@x @x
If @I = 0; If @I = 0;
< 0; then x is an inferior good < 0; then x is an inferior good
> 0; then x and y are substitutes
@x
If @py = 0; then x and y are independents
< 0; then x and y are complements
> 1; then x is a luxury/superior good
If ex;I > 0 and ex;I = 1;
< 1; then x is a necessity

Snyder and Nicholson’s de…nition (p.136):

@x
– normal good if @I
>0
– normal = non-inferior

Hirshleifer’s de…nition:
@x
– superior good if @I
>0
– x and y are normal superior goods if the income expansion path is positively
sloped
– x is an inferior good and y is an ultra-superior good if the income expansion
path is negatively sloped

67
Under De…nition I,
@x ;
<0 x is a normal good
@px (

@x ;
<0 x is an inferior good
@px :

@x )
>0 x is an inferior good
@px :

(ii) The Slutsky Equation

The substitution e¤ect and the income e¤ect can be represented mathematically.

@x @x @x
= x (24)
@px @px U =constant @I
= S:E: + I:E:

p q
I py @x I @xc
Example: U = xy; x = 2px
and xc = V px
: Then @px
= 2p2x
and @px
=
p
V py I I
2(px )3=2
= 4p2x
(since V = p
2 px py
): In addition, x @x
@I
= x 2p1x = I
4p2x
: Hence,
@x @xc
@px
= @p x
x @x
@I
; verifying the Slutsky equation.

p p Ipy V 2 p2y @x Ipy (2px +py )

Example: U = x+ y; x = px (px +py )
and xc = (px +py )2
; @px
= p2x (px +py )2
;
q
@xc 2V 2 p2y 2Ipy I(px +py ) Ip2y
@px
= (px +py )3
= (px +py )2
(since V = px py
); x @x
@I
= p2x (px +py )2
: Hence, @x
@px
=
@xc
@px
x @x
@I
; verifying the Slutsky equation.

68
(iii) Uncompensated and Compensated Demand Curves
Uncompensated (Marshallian, Ordinary) demand curve: x = d(px ; py ; I)

– The uncompensated demand x depends on px ; py ; and I:

Compensated (Hicksian) demand curve: x = h(px ; py ; U )

– The compensated demand x depends on px ; py ; and U:

From Indi¤erence Curves to a Demand Curve: Hicksian (Compensated) Demand

Curve

Compensated Demand Curve

y px
6 6
AD
@
D A@
D A @
D A @ t
qq D A @
qq D A
p0x
qq t
qqDt A
@
qqD
@
qqq qDqq q
p00x
A @
qqq qq
qqqD qqt A t
A @
qqq qq
D qqqqq
@
p000
D qqqqq A
A @ x

D qqqqqqqq t A
@
D qqqq qqqqq A
@
qq qq A q
@
qq qqq
qq qqAq
D @ D
qq qqq
qq qqq
D @
qq
AAqqqqq
D A @
DD qq U1 @6
@ - -
6 6
x1 x2 x3 x x1 x2 x3 x

p0x x + py y = I p00x x + py y = I p000

x x + py y = I

Is the uncompensated demand curve more elastic than the compensated demand
curve?

69
 Uncompensated Demand xu and Compensated Demand xc
xu = d(px ; py ; I); x0u = d(p0x ; py ; I); xc = h(px ; py ; U0 ); x0c = h(p0x ; py ; U0 )
6
y
Z
J
JZZ
J Z
J Z
J Z
Z
J Z
pp
J Z
pp
Z
pp
J Z
pp
pp J Z uB
J Z
pp u
p pJ
pp
Z
A Jp pJp p C
Z
Z
ppu
J pppp
Z
Z
J ppp
Z
p
U1
pp
Z
pp
Z
pp
J
p
Z
p
J
pp
Z
p pp
J Z
pp
Z U0
pp
J
pp
J Z
p
Z
J Z p0x x + py y = I
J p x x + p y y = I Z
J Z - x
xu x0 x0u
c
xc
p
Consider the Cobb-Douglas utility function U = xy:
I
At the tangency point A; the uncompensated demand is xu = 2px
, where the sub-
script u on x indicates that it is the uncompensated demand.
Atq
the tangency point A; the utility is U0 ; hence the compensated demand is xc =
U0 ppxy ; where the subscript c on x indicates that it is the compensated demand.
The proof is as follows. At the tangency A; UUxy = xy = ppxy , which imples y = ppxy x:
r q
p
It follows that U (x; y) = xy = x ppxy x = x ppxy : At the tangency point A;
q q
U (x; y) = U0 ; i.e., U (xc ; yc ) = U0 ; hence U0 = xc ppxy : It follows that xc = U0 ppxy :

If the price of x goes down from px to p0x ; then the tangency moves from point A to
point B and the uncompensated demand becomes x0u = 2pI 0 : The tangency moves
x q
from point A to point C and the compensated demand becomes x0c = U0 pp0y :
x

Example: Let px = 0:25; py = 1; I = 2; and U0 = 2: At the tangency point A;

the uncompensated demand is xu = 2pI x = 2 20:25 = 4: The compensated demand is
q q
py 1
xc = U0 px = 2 0:25 = 4: Hence, xu = xc = 4:

Suppose p0x = 0:1: At the tangency point B; the uncompensated demand becomes
x0u = 2pI 0 = 2 20:1 = 10: At the tangency point C; the compensated demand becomes
x
q q
x0c = U0 pp0y = 2 0:1 1
= 6:325:
x

70
5. Market Demand Curve
How to obtain the market demand curve from individual demand curves?

Individual Demand Curves

px Consumer A px Consumer B
6 6
6

- -
4 x 5 x

Market Demand Curve

px Market = Consumer A + Consumer B

-x

71
Demand Relationships between Goods
1. Cross-price E¤ect
A cross-price Slutsky equation:
@x @x @x
= y (25)
@py @py U =constant @I

@x
@px
= own-price e¤ect

@x
@py
= cross-price e¤ect

@x
@py
= substitution e¤ect
U =constant

y @x
@I
= income e¤ect.

p q
I py @x @xc V
Example: U = xy; x = 2px
and xc = V px
: Then @py
= 0 and @py
=
p
2 px py
=
I I
4px py
(since V = p
2 px py
): In addition, y @x
@I
= y 2p1x = I
4px py
: @x
Hence, @p y
=
@xc
@py
y @x
@I
; verifying the Slutsky equation.

p p Ipy V 2 p2y @x I
Example: U = x+ y; x = px (px +py )
and xc = (px +py )2
; @py
= ; @x
(px +py )2 @py U =constant
=
q
2V 2 px py 2I I(px +py )
= (p +p
(px +py )3 2 (since V = px py
); y @x
@I
= I
(px +py )2
: Hence, @p@x @xc
= @p y @x
@I
;
x y) y y
verifying the Slutsky equation.

72
2. Gross Substitutes and Complements
@x
x and y are gross substitutes if @py
>0

@x
x and y are gross complements if @py
<0

@x @x @x
Suppose that @I
> 0 (normal good); then @py
> 0 if the substitution e¤ect ( @py
)
U =constant
dominates the income e¤ect ( y @x
@I
).

@x
Conversely, @py
< 0 if the income e¤ect dominates the substitution e¤ect.

@x @y
Does @py
> 0 imply that @px
> 0?

1. Refer to the …gures in the following two pages.

@x @y
2. Example: U (x; y) = ln x + y: Find @py
and @px
:

73