Demand - Basic Review and Examples1

The Basic Demand Form

What exactly is a demand function? In Varians words, a consumers demand functions

give the optimal amounts of each of the goods as a function of the prices and income faced
by the consumer2 . Basically, that means that if we know the prices of the goods of interest
and the consumers income, we can plug all that into the demand function for any particular
good to find out how much of that good the consumer will want to consume. For example,
if we have goods x1 and x2 with prices p1 and p2 respectively, and an income m, then we
can write the two demand functions as:
x1 = x1 (p1 , p2 , m) and x2 = x2 (p1 , p2 , m)
A demand function always needs to have the quantity demanded on one side and the
prices and income on the other side. A demand function cannot, repeat, cannot have a
variable that represents another good in it anywhere. In other words, the demand function
for x1 cant have x2 in it anywhere. A demand function should only be a function of prices
and income, not the demand of other goods.
We like demand functions because they let us see how consumers will react to changes
in prices and incomes. Say a consumers income goes up . . . will he consume more or less
of x1 ? If he consumes more, x1 is called a normal good. If he consumes less, x1 is called
an inferior good. Mathematically, we can express this as a discrete change or, if the utility
function is differentiable, we can write it as the partial derivative of the utility function with
respect to income m (see Table 1). Note that these functions work for decreases in income
as well. For normal goods, demand decreases as income decrease, while for inferior goods,
demand increases as income decreases.
What about changes in prices? We have two to consider here - changes in a goods own
price, and a changes in the price of the other good. First, lets consider changes in a goods
own price (e.g. how changes in p1 affect demand for x1 ). If a goods price goes up and
demand goes down, the good is an ordinary good. If demand goes up when price increases,
the good is a Giffen good - such goods are pretty rare (see Table 2).
1

Disclaimer : This handout has not been reviewed by the professor. In the case of any discrepancy
between this handout and the lecture, the lecture material should be considered the correct source.
2
Hal Varian, Intermediate Microeconomics : A Modern Approach (New York: W. W. Norton & Company,
2006 7th ed), 95
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2007

normal good

discrete case
x1
>0
m

inferior good

x1
m

<0

derivative
x1
>0
m
x1
m

<0

Table 1: Changes in demand with respect to (w.r.t.) income.

What about how demand changes when the price of the other good changes (e.g. how
changes in p2 affect demand for good x1 )? If demand goes up as the other goods price
goes up, then the goods are substitutes. If demand goes down as the other goods price goes
up, then the goods are compliments (see Table 3). Note that these definitions only work
nicely if we have just 2 goods . . . any more than that, and the relationships can get really
complicated.

ordinary good
Giffen good

discrete case
x1
<0
p1
x1
p1

>0

derivative
x1
<0
p1
x1
p1

substitutes

>0

discrete case
x1
>0
p2

compliments

Table 2: Changes w.r.t. own price.

x1
p2

<0

derivative
x1
>0
p2
x1
p2

<0

Table 3: Changes w.r.t. other price.

Example - Normal or Inferior? Compliment or Substitute?

Say we have the demand function x1 (p1 , p2 , m) = 4p2m
. Is good 1 a normal or inferior good?
+2p1
1
Is good 2 a compliment or a substitute? Using the partial derivative trick, x
= 4p21+p1 > 0,
m
which means as income increases, demand for x1 increases, so it is a normal good. Again using
1
partial derivatives, x
= (4p24m
< 0 telling us the goods are imperfect compliments.
p2
+p1 )2

Income Offer Curves and Engel Curves

We can graphically represent the relationship between demand and income using one of two
curves, the income offer curve (also called the income expansion path) or the Engel curve.
Both show how the demand for goods changes as income changes - so whats the difference?

u3
u1

u2
x1

x2

Three bundles of x1(p1,p2,m),

x2(p1,p2,m) for three different
levels of m we can connect them
to get the income offer curve

x1(p1,p2,m) for three

different levels of m
three points on an Engel
curve

u3
u1

u2
x1

x1

Figure
1: An income offer curve (left) and an Engel curve (right). The income offer curve
m
x1(p1,p2,m)
shows all the optimal
(x1for
, x2three
) bundles for a given set of prices and a changing income, while
different levels of m
the Engel curve shows the demand for one good under a set of fixed prices and changing
income.

2.1

Income Offer Curve

The income offer curve is a graph with good 1 on the x-axis and good 2 on the y-axis.
As income increases, the budget set shifts outward, and we get different bundles that the
consumer will choose. If we were to connect all these different optimal bundles, we would get
the income offer curve - the locus3x1of all optimal bundles under a set of unchanging prices
as income increases.

2.2

Engel Curve

The Engel curve is a graph with the demand for a certain good on the x-axis and income
on the y-axis. Looking at only good 1, as we shift the budget line outward (again keeping
prices unchanged), well get different demand quantities for good 1. Connecting all those
points gives us the Engel curve, which shows how (in this case) demand for good 1 changes
as income changes. If the Engel curve has a positive slope, the good is a normal good. If it
has a negative slope, the good is an inferior good.
3

What the heck is a locus? Its just a fancy way of describing a selection of points that all meet a
particular criteria. In this case, the criteria is the optimal demand bundle under certain conditions.

levels of m we can connect them

to get the income offer curve

u3
u2

u1

Example - An Engel Curve for Cobb-Douglas Preferences

x1

Say we have the following Cobb-Douglas demand functions and

prices.
x (p ,p ,m) for three
m
1

1m
2 p1
1m
x2 (p1 , p2 , m) =
2 p2
x1 (p1 , p2 , m) =

different levels of m
three points on an Engel
curve

p1 = 1
p2 = 2

Lets graph the Engel curve for good 1. First, we can start with some easy values of
m, and then we can graph the line in x1 and m space, as shown below. Note that
our
x
1

x1 (p1 , p2 , m)
0.5
1
1.5
2
2.5

m
1
2
3
4
5

x1

Figure 2: An example of graphing an Engel curve.

Engel curve is linear (has a constant slope). Thats a product of the fact that Cobb-Douglas
preferences are part of a group called homothetic preferences, which all have linear Engel
curves. The slope of the Engel curve here is 2. How do we know? Well, we can look at the
graph, for one. We can also rearrange the demand equation until income is on one side and
demand for x1 is on the other.
m = 2p1 x1
As p1 = 1 here, we get a slope of 2. In general, if we have a utility function u(x1 x2 ) =
that represents Cobb-Douglas preferences (where a + b = 1), the slope of the Engel
curve is p1 /a for good 1 and p2 /b for good 2.
cxa1 xb2

Price Offer Curves, Demand, and Inverse Demand

The price offer curve is the analog of the income offer curve, but now we hold income and the
price of the other good constant and change own price. As own price changes, the budget
line rotates, again giving a locus of optimal choice points. If we were to graph these points
4

in x1 and x2 space, we would get the price offer curve for one of the goods. The analog of
Engel curve is the demand curve, which graphs the relationship between a the price of a
good and its demand (see Varian, page 106 for some graphs).
We can also talk about an inverse demand curve. While a regular demand curve puts
quantity demanded in terms of price, the inverse demand curve puts price in terms of quantity
demanded. If were given some quantity demanded, we can use the inverse demand curve to
say what price we would have to see in the market for that to happen. When considering
the inverse demand curve, we hold income and the price of all other goods constant.
Example - Using Inverse Demand Curves
Take the demand function for good 1 that we had in the last example. Given that the
demand for good 1 is 12 and income is 30, what is p1 ? If we were to solve this for price in
terms of quantity demanded, we would get
x1 (p1 , p2 , m) =

1m
1m
p1 =
2 p1
2 x1

Plugging in our values for x1 and m

p1 =

1 30
5
=
2 12
4

Putting it all Together

Time for the whole shabang . . . well start with a utility function, derive its demand
functions, an Engel curve, and use an inverse demand curve to find a price.
Example - Cobb-Douglas All the Way
Say we have a utility function of the form u(x1 , x2 ) = 3x31 x92 . The price of good 2 is 6, and
income is 40. What is the slope of the Engel curve for good 2? If demand for good 1 is 10,
what is p1 ? Write this utility function in the usual form of u(x1 , x2 ) = cx1 x21 .
4.0.1

The Answer Process

To answer both parts of this question, we need demand functions. How do we solve for
those? First, since we have Cobb-Douglas preferences, we get a nice interior solution, and

we can find the optimal bundle by setting the negative of the price ratio equal to the MRS.

p1
M U x1
=
p2
M U x2
3 3x21 x92
=
3 9x31 x82
3
= x123 x298
9
1 x2
=
3 x1

(1)

(2)

Remember, when were solving for demand functions, were asking how much someone will
want of goods 1 and 2 when theyre at their optimal bundle. Since Cobb-Douglas preferences
are monotonic, we know that at the optimal point well be spending all our budget. That
means we now have two equations to work with:

p1
1 x2
=
p2
3 x1

(3)

m = p 1 x1 + p 2 x2

(4)

We can solve for demand functions by using (3) to get x1 in terms of x2 and plugging that
into (4).

1 x2
p2 1
p1
x2
=
x1 =
p2
3 x1
p1 3
p2 1
m = p1
x2 + p 2 x2
p1 3

using (3)

(5)

plugging (5) into (4)

(6)

Now we can solve for x2 in terms of p1 ,p2 , and m.

p2 1
x2 + p 2 x 2
p1 3
1
m = p 2 x2 + p 2 x2
3
4
m = p 2 x2
3
m = p1

x2 (p1 , p2 , m) =

3m
4 p2

Now using (5), we can solve for x1 .

x1 (p1 , p2 , m) =
6

p2 1 3 m
p1 3 4 p 2

(7)

x1 (p1 , p2 , m) =

1m
4 p1

(8)

We now have two general demand functions for good 1 and good 24 . To find the slope of
the Engel curve for good 2, we take (7) and get income on one side and all other variables
on the other.
m = 43 p2 x2

(9)

giving us a slope of 43 p2 = 43 6 = 8. Now for part 2 of the question. Using (8), we can derive
the inverse demand function for x1 .
x1 (p1 , p2 , m) =

1m
1m
p1 =
4 p1
4 x1

(10)

1 40
4 10

(11)

Plugging in our given values

p1 =

=1

Almost done - now all we have to do is write this utility function in the usual Cobb-Douglas
1
1
format. To do that, we raise the whole utility function to the power of 3+9
= 12
, which is
a monotonic transformation as long as were dealing with only positive values5 . Lets say
1
v (u()) = u() 12 . Then we have
v(x1 , x2 ) = 3x31 x92
3

121
9

= 3 12 x112 x212

v(x1 , x2 ) = 3 12 x14 x24

(12)

Now = 41 and (1 ) = 34 , and c = 3 12 . Remember back when we found that the slope
of the Engel curve for good 2 using a utility function representing Cobb-Douglas preferences
could be expressed as p2 /b? Well, for good 1, we can now say b = 34 , which would mean that
equation for the Engel curve would be p2 / 34 = 43 p2 , which is what we found in equation (9)
- ta-da!
4

We could have taken a shortcut to get here - remember that with utility functions of the form u(x1 , x2 ) =
a m
b m
we always get x1 (p1 , p2 , m) = a+b
p1 and x2 (p1 , p2 , m) = a+b p2 . However, knowing HOW we get the
end result is more important than just knowing the end result.
5
In general, if our Cobb-Douglas function is of the form u(x1 , x2 ) = dx1 x2 and we want to get to
1
1
u(x1 , x2 ) = cx
, we can raise it to the power of +
.
1 x2

cxa1 xb2 ,