4

Consumer Behavior
Introduction 4

Chapter Outline
4.1 The Consumer’s Preferences and the Concept of Utility
4.2 Indifference Curves
4.3 The Consumer’s Income and the Budget Constraint
4.4 Combining Utility, Income, and Prices:
What Will the Consumer Consume?
4.5 Conclusion
Introduction 4
How do consumers make purchases?
• This chapter introduces a theory of consumer behavior
• The theory is used to investigate why consumers make
purchases
• Ultimately, consumers are assumed to “optimize” their
utility given scarce resources
• Consumer theory is the basis for the “demand” side of the
supply and demand model
The Consumer’s Preferences and
the Concept of Utility 4.1
Economists assume consumers are rational and able to “optimize”
consumption decisions given scarce resources

Four assumptions about consumer preferences

1. Completeness and rankability
• Consumers can compare bundles of goods and rank them
2. For most goods, more is better than less
• Non-satiation and “free disposal”
3. Transitivity
• Imposes consistency on rankings
4. The more a consumer has of a particular good, the less she is
willing to give up of something else to get even more of that good
• Referred to as “diminishing marginal utility”
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
Utility is a measure of how “satisfied” consumers are
• A measure of happiness or satisfaction
• Provides a theoretical basis for decision theory

A utility function describes the relationship between what

consumers actually consume and their level of well-being
• Can take a variety of mathematical forms
• Common assumptions: continuous, differentiable, concave
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
Consider the utility someone enjoys from seeing a movie in a theater vs.
watching a DVD
U =U (T, D)

where T is the number of movies “consumed” at the theater, and D is

the number of DVDs consumed at home. Utility might be represented by
U = T 0.8 D0.2

In general, movies consumed in the theater add more utility than those
consumed at home
* this particular functional form is referred to as “Cobb–Douglas”
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
Marginal utility is the additional utility a consumer receives from
an additional unit of a good or service.
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
Continuing the previous example, the marginal utility of theater-movies
for this consumer is given by
DU (T, D) dU (T, D)
MUT = =
DT dT
or, with the prescribed parameters
MUT = 0.8T -0.2 D0.2
The Consumer’s Preferences and
the Concept of Utility 4.1
Comparing Consumption Outcomes
The “rules” for utility allows only for an ordinal ranking of
consumption bundles
• An ordinal ranking implies bundles can be ranked from best to worse
• A cardinal ranking would allow a person to determine how much
better one bundle is, compared to another

Why not cardinal?

• Many questions can be answered with only an ordinal ranking
– Ex: Predicting what will be consumed
• Consumers differ in preferences
‒ Ex: Both between consumers and over time
Indifference Curves 4.2
Ordinal rankings mean we care about relative outcomes
• Some bundles are better than others, some are worse
• Start by considering bundles that are relatively equal

A consumer is indifferent between bundles when he or she

derives the same utility level from two or more bundles.

An indifference curve plots out all of the consumption

bundles that provide a consumer with the same level of
utility or satisfaction.
Indifference Curves 4.2
Figure 4.1 Building an Indifference Curve

Number
of friends
living in
building
A
10

B
5
C
3
Indifference
curve (U)

0 500 750 1,000 Apartment size (square feet)

Indifference Curves 4.2
Characteristics of Indifference Curves
1. They can be drawn
• Completeness and rankability
2. Curves further from the origin represent higher utility
• More is better
3. Curves never cross
• Transitivity
4. Convex to the origin
• Diminishing marginal utility
Indifference Curves 4.2
Figure 4.2 A Consumer’s Indifference Curves

Number
of friends U2 has a
living in greater utility
building

than U1
5

U2

U1

0 500 1,000
Apartment size (square feet)
 Indifference Curves 4.2
Indifference curves can never cross
Call our movie watcher, Joe
Movies at the
Theater To see why indifference curves cannot cross,
consider bundles D and F
• These bundles are on the same indifference
curve, therefore Joe must be indifferent between
them
F
E
Now, draw another indifference curve through
bundle F that intersects the original curve
D • Implies Joe is also indifferent between points E
and F as well as between points E and D

 Why must Joe prefer bundle E to bundle D?

DVDs ‒ If more is better, at E he has more of
both
Indifference Curves 4.2
Figure 4.4 Tradeoffs Along an Indifference Curve

As apartment size gets larger, Michaela

is less willing to trade off the number
Number of friends for additional apartment size.
of friends
living in A
building

B
U1

0 500 1,000
Apartment size (square feet)
Indifference Curves 4.2
The Marginal Rate of Substitution
Indifference curves describe tradeoffs
• How much of one good you are willing to give up for one more unit of
another good
• The slope of the indifference curve captures this tradeoff
We call this slope the marginal rate of substitution
Y
MRS XY  
X

Describes the rate at which one is willing to trade off or substitute

exactly 1 unit of good X for more of good Y, and be equally well
off.
Indifference Curves 4.2
Figure 4.5 The Slope of an Indifference Curve is the
Marginal Rate of Substitution
Burritos
As you move down an indifference
curve, you experience a diminishing
marginal rate of substitution
A

Slope = –2

B
Slope = –0.5 U
Lattes
Indifference Curves 4.2
The Marginal Rate of Substitution and Marginal Utility
Consider point A from the previous figure
Y  Qburritos
MRS XY   2
X Qlattes
Sarah is willing to give up one latte (X) to gain two burritos (Y), vice versa;

What does this mean in terms of the change in Sarah’s level of utility?
U  MU lattes  Qlattes  MU burritos   Qburritos 0

The change in utility is zero... she is just as well off! Rearranging,

 MU burritos   Qburritos  MU lattes  Qlattes
 Qburritos MU lattes
and finally: MRS XY   
Qlattes MU burritos
Indifference Curves 4.2
The Marginal Rate of Substitution and Marginal Utility
The MRS between two goods is equal to the inverse of the goods’
marginal utilities:
Qburritos MU lattes QY MU X
MRSlb    or MRS XY   
Qlattes MU burritos QX MU Y
Observing the tradeoffs that consumers make provides insight as to the
relative marginal utilities of goods!
What does it mean if the slope of an indifference curve is steeper?
Flatter?
• Steeper curves imply the consumer is willing to give up a lot of Y to get one
unit of X, or could trade 1 unit of X for a lot of good Y
• Flatter curves imply the consumer would require a large increase in good X
to give up one unit of the good Y, or could trade 1 unit of Y for a lot of good X
Indifference Curves 4.2
Figure 4.6 The Steepness of Indifference Curves
Indifference Curves 4.2
The Curvature of Indifference Curves: Substitutes and Complements
The shape of indifference curves reveals information about the relationship
between products
• Relatively straight indifference curves describe goods that are more easily
substitutable for one another
• Indifference curves that are more convex to the origin describe goods that are
more complementary to one another

To illustrate, consider extreme cases

i. Perfect substitutes are goods that the consumer will trade at a fixed rate and
receive the same level of utility (MRS is constant)
ii. Perfect complements are goods that the consumer must consume in a fixed
proportion
Indifference Curves 4.2
Perfect substitutes
2-liter bottles of
root beer

4
Consider a typical consumer’s
preferences for 1- and 2-liter soda bottles
3 This consumer should be willing to trade
one 2-liter bottle for two 1-liter bottles no
2 matter how much of each he or she has

1
MRS is constant in this case

U1 U2 U3 U4
0 2 4 6 8 1-liter bottles of
root beer
Indifference Curves 4.2
Perfect complements

Alternatively, consider preferences for

Hotdogs hotdogs and hotdog buns
Most consumers will prefer to consume
C these goods in constant proportion
3 U3
Consider point A ; this consumer has two
A B
2 U2 hotdogs and two buns
Adding another hotdog bun (bundle B )
1 U1 will not increase utility
The consumer needs another hotdog as
0 1 2 3 Hotdog buns well (bundle C ) if utility is to increase
Indifference Curves 4.2
Figure 4.8 The Curvature of Indifference Curves
Indifference Curves 4.2
Figure 4.11 The Same Consumer Can Have Indifference
Curves with Different Shapes

Initially, for low levels of utility

(UA), bananas and strawberries
might be substitutes.

As utility increases (UB), the

consumer might prefer a variety
of fruit in their diet more than
initially.
The Consumer’s Income and the
Budget Constraint 4.3
The budget constraint is a curve that describes the entire set of
consumption bundles a consumer can purchase when spending all of
their income. It is generally plotted alongside indifference curves.
• For two goods (X and Y), mathematically:

Income = PX Q X + PY QY
To find the slope of the budget constraint, solve for QY
Income PX
QY =  Qx
PY PY
Returning to the burrito/latte example, and setting income to $50, the
price of lattes to $5, and the price of burritos to $10 yields
1
Or, graphically, QY = 5  Q X
2
The Consumer’s Income and the
Budget Constraint 4.3
Figure 4.14 The Budget Constraint

Burritos
I B
Py = 5 Slope is negative because
purchasing more lattes means
less income for Burritos.
4 Infeasible

C
3

2 Px Why does the

Slope = - = −5/10= − 1/2
Feasible
Py budget constraint
1 slope downward?
A
0 I
2 4 6 8 = 10 Lattes
Px
The Consumer’s Income and the
Budget Constraint 4.3
Factors that Affect the Budget Constraint’s Position
The slope and position of the budget constraint are a function of two
factors: income and relative prices
1. Changes in income shifts the budget constraint by changing the intercepts
2. Changes in the price of one good pivots the budget constraint by changing
the slope

Consider again the budget constraint for burritos and lattes. The graphs
on the next slide represent the following changes:
(a) Doubling of the Price of Lattes
(b) Doubling of the Price of Burritos
(c) Reduction in Income by 1/2
The Consumer’s Income and the
Budget Constraint 4.3
Figure 4.15 The Effects of Price or Income Changes on the
Budget Constraint
(a) (b) (c)

Burritos Burritos Burritos

B Old budget B Old budget B Old budget
5 constraint 5 constraint 5 constraint
New budget New budget
constraint with higher constraint with higher 4 New budget
4 4
price for lattes price for burritos constraint with
lower income
3 3 3
Loss of feasible B' Loss of feasible B' Loss of feasible
bundles bundles bundles
2 2 2

1 1 1
Feasible Feasible Feasible
bundles bundles bundles
A' A A A' A
0 0 0
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10
Lattes Lattes Lattes
The Consumer’s Income and the
Budget Constraint 4.3
Nonstandard Budget Constraints
Quantity discounts
• Sometimes, consumers may secure a discounted price if a minimum quantity of
a good is purchased (e.g., buy two, get one free)
• This results in a kink in the budget constraint

Ex: Income = $100; Ppizza = $10 and Pminute = $0.10

• Initially, the consumer could consume 10 pizzas or 1,000 phone minutes if spent
all of their income on either product; Result is normal linear budget constraint
‒ Introduce a quantity discount of $.05 per minute for every minute used over 600
‒ Result is a kink at 600 minute (and 4 pizzas) because every minute over 600
now only costs $0.05 compared to $0.10 originally

• Graphically,
The Consumer’s Income and the
Budget Constraint 4.3
Figure 4.16 Quantity Discounts and the Budget Constraint
Phone
minutes

1,400

5 cents/minute
Infeasible
1,000 Feasible

600
10 cents/minute

Feasible

0 4 10 Pizzas
The Consumer’s Income and the
Budget Constraint 4.3
Nonstandard Budget Constraints
Quantity limits
• Alternatively, there may be limits on how much of a good can be purchased
(e.g., gasoline in the 1970s)

Ex: Income = $100; Ppizza = $10 and Pminute = $0.10

• Now, instead of a discount after 600 minutes the phone company puts a cap
at 600 minutes so his phone will not work after the 600th minute
‒ Result is a kink in the opposite direction as before at 600 minutes

• Graphically,
The Consumer’s Income and the
Budget Constraint 4.3
Figure 4.17 Quantity Limits and the Budget Constraint
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
The concepts of utility and indifference curves describe consumer
preferences; the budget constraint describes which bundles are feasible
Combining these concepts, we can begin to understand consumer
choices

Solving the Consumer’s Optimization Problem

Consumers face a constrained optimization problem
• Maximize utility, subject to income and market prices

The optimal choice can be interpreted most easily using a graph

Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
Utility Maximization

Good Y
With one budget constraint,
search for indifference curve
that maximizes utility

A
U2

U*

U1
BC*
Good X
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
Tangency is the key to finding the optimal bundle, and occurs
• where the slope of the indifference curve is equal to the slope of the budget
constraint
‒ i.e. when the marginal rate of substitution is equal to the price ratio

Mathematically,
Slope of indifference curve  Slope of budget constraint

MU X PX
 MRS XY  
MUY PY
MU X PX

MUY PY
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
What does this imply? Rewriting the tangency condition yields

MU X PX MU X MUY
  
MUY PY PX PY
The consumer finds the consumption bundle that provides the most
benefit on a cost-adjusted basis
• Occurs when marginal utility per dollar spent is equalized across all products

MU X MU Y
 What does it imply if  ?
PX PY

‒ Marginal Utility per dollar spent on good X is more than good Y.

• Getting more utility per dollar from X so you should consume more of
good X until the MUX decreases until the ratio is equal
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
Implications of Utility Maximization
What if two consumers have different preferences?
• Will they have the same MRS at their optimal bundles?
Yes! Because they face the same ratio of prices!
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
Figure 4.19 The Consumer’s Optimal Choice
Jack prefers
gum over iTunes Although they have different
Gum optimal consumption bundles,
the MRS for both are the same
UM
at points J and M because they
face the same prices
J

UJ

Meg prefers
iTunes over gum
Budget constraint
M

iTunes
Conclusion 4.5
This chapter introduced the underlying mechanisms behind
consumer choice
• Preferences
• Prices and income

In Chapter 5, we make the link between consumer behavior and

individual and market demand
 5

Individual and Market Demand

Introduction 5

Chapter Outline
5.1 How Income Changes Affect an Individual’s Consumption Choices
5.2 How Price Changes Affect Consumption Choices
5.3 Decomposing Consumer Responses to Price Changes into Income and
Substitution Effects
5.4 The Impact of Changes in Another Good’s Price: Substitutes and
Complements
5.5 Combining Individual Demand Curves to Obtain the Market Demand
Curve
5.6 Conclusion
Introduction 5
With the consumer choice framework in place, we now link
consumer decisions with individual and market demand

These links help determine:

• Why shifts in tastes affect prices
• What benefits producers offer consumers
• How income and wealth affect purchase patterns
• What determines how consumers respond to price changes
How Income Changes Affect an
Individual’s Consumption Choices 5.1
The income effect is the change in optimal consumption choices
associated with a change in income (or purchasing power),
holding relative prices constant

Is higher income associated with higher consumption of goods?

It depends!

For normal goods, higher income is associated with rising

consumption
• For instance, consider Vacations and Basketball Tickets, both of
which are considered normal goods
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Figure 5.1 A Consumer's Response to an Increase in
Income When Both Goods Are Normal
Vacations
Income
rises

B
Q’v
Qv A

U2
U1

BC1 BC2

Qb Q’b Baseball Tickets

How Income Changes Affect an
Individual’s Consumption Choices 5.1
The income effect is the change in optimal consumption choices
associated with a change in income (or purchasing power),
holding relative prices constant

Is higher income associated with higher consumption of goods?

It depends!

Alternatively, for inferior goods, higher income is associated with

falling consumption
• Consider boxed macaroni and cheese (an inferior good) vs. steak (a
normal good)
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Figure 5.2 Consumer's Response to an Increase in Income
When One Good is Inferior
Quantity of
Mac and
cheese

Qmac A

Q’mac B

U1 Income
U2 rises

BC1 BC2

Qs Quantity
of steak
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Income Elasticities and Types of Goods
Chapter 2 introduced the concept of elasticity
• Income elasticity describes the response of demand to changing income
‒ Specifically, the percentage change in quantity consumed associated
with a percentage change in income

%Q Q / Q Q I
Mathematically, E 
D
 
%I I / I I Q
I

where I is income and Q is the quantity of a good demanded

Q
The income effect is given by
I
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Income Elasticities and Types of Goods
Thus, the sign of the income elasticity is the same as the income effect

Q
If E  0   0 , the good in question is a normal good
D

I
I

Q
If E  0   0 , the good in question is an inferior good
D

I
I
How Income Changes Affect an
Individual’s Consumption Choices 5.1
There are two additional sub-types of goods that are common, both of
these are classified as normal goods because as income increases,
the quantity demanded for them increases as well and vice versa

• Necessity goods: normal goods for which income elasticity is between 0

and 1
‒ Examples: water consumption, electricity, clothing, etc…

• Luxury goods: normal goods for which income elasticity is greater than 1
‒ Examples: vacation homes, jewelry, expensive steaks, etc…
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Tracing the optimal bundle of goods chosen as income increases
results in the income expansion path
• Helps determine whether a good is normal or inferior, but only two
goods can be represented
• Can’t directly observe income levels on the curve because both axes
represent quantities of goods

A more common way to describe the consumption-income

relationship is with an Engel curve
• Shows the relationship between quantity consumed of one good and
consumer income
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Figure 5.3 The Income Expansion Path
How Income Changes Affect an
Individual’s Consumption Choices 5.1
Figure 5.4 An Engel Curve Shows How Consumption Varies
with Income
Income Income
At point D Bottled water
/ week / week
rides become is normal at all Engel
$35 Engel inferior $35 income levels
curve curve
E E
30 30
D
25 D 25
C
20 C 20
B
15 15
B
10 A 10 A

5 5

0 1 2 3 4 5 6 7 8 Bus 0 1 2 3 4 5 6 7 8 9 Bottled
rides water
How Price Changes Affect
Consumption Choices 5.2
Just as income affects consumer choices, changes in relative prices—
holding income constant—also affects these choices

Deriving a Demand Curve

• Demand curves define a relationship between quantity demanded
and price
• To derive a demand curve, we must understand how a consumer
responds to a change in price
• By changing one price on an indifference curve—budget constraint
map, we can observe changes to consumer choices and then build
the demand curve for an individual using these observed changes
• The observed price represents the maximum willingness to pay for
the last unit consumed
How Price Changes Affect
Consumption Choices 5.2
Figure 5.7 Building an Individual's Demand Curve
Mountain Dew
PG = 4 PG = 1
(2 liter bottles) Income = $20
PG = 2 PG = $1
10
PMD = $2

4
3
2 U3 U1
U2
0 3 5 8 14 20
10
Quantity of grape juice
(1 liter bottles)

Price of
grape juice
($/bottle)

Carolyn’s
$4 demand for
2 grape juice
1
0
3 8 14
Quantity of grape juice
(1 liter bottles)
How Price Changes Affect
Consumption Choices 5.2
Shifts in the Demand Curve
When consumer preferences, income, or the prices of other goods
change, the demand curve will shift

Consider the example of Mountain Dew and grape juice from the
previous figure
• Imagine the consumer (Caroline) prefers the taste of Mountain Dew, but had
previously limited consumption due to worries about high fructose corn syrup
• After hearing advertisements from the Corn Refiners Association claiming
corn syrup is identical to cane sugar, her fears are reduced

 What might happen to the demand for grape juice?

‒ In order to consume more Mountain Dew, she might reduce her consumption of
grape juice
How Price Changes Affect
Consumption Choices 5.2
Figure 5.8 Preference Changes and Shifts in the Demand
Curve
Quantity of
Mountain Dew (a) Caroline’s indifference curves for
PG = 4 PG = 1
(2 liter bottles) grape juice flatten when her
PG = 2
10 preference for grape juice decreases
relative to her preference for
6 Mountain Dew. At each price level,
5.5
4 she now consumes fewer bottles of
PG = 4 PG =U22 U
P1 = 1 grape juice.
U3 G

0 2 6 9 20
Quantity of grape juice
(1 liter bottles)

Price of
grape juice (b) Because she purchases fewer
($/bottle) bottles of grape juice at each price
point, Caroline’s demand curve for
grape juice shifts inward from D1 to
$4 D2 D2.
2
1 D1
0 2 6 9
Quantity of grape juice
(1 liter bottles)
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
When the price of a good changes relative to another, two things happen
1. One good becomes relatively more expensive, and the other relatively less
2. The total purchasing power of a consumer’s income changes

The substitution effect refers to the change in consumption choices

resulting from a change in relative prices
• Always negative; when the price of one good relative to another increases,
consumption of the former falls, and vice versa
The income effect refers to the change in consumption choices
resulting from a change in purchasing power
• This is the same income effect from Section 5.1
• Can be negative or positive (inferior or normal goods)
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Figure 5.9 The Effects of a Fall in the Price of Basketball
Tickets
Concert
Tickets

B
Total 6
effect A
5
U2

U1
BC1 BC2
0 3 5 Basketball
tickets

Total effect
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
The total effect of a change in a price is the sum of the
substitution and income effects
• The total effect is simply the observed change in consumption of a
good after a price change

Total Effect = Substitution Effect + Income Effect

Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3

Total Effect = Substitution Effect + Income Effect

Isolating the Substitution Effect

• Determine the bundle of goods that would have been chosen
at the new price while maintaining utility experienced before
the price change
• Graphically: on the next slide
‒ To do this for a fall in the price of basketball tickets, shift the new
budget constraint (BC2) inward until it is tangent with the old
indifference curve (BC′)
‒ Movement along the original indifference curve (A to A′)
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Figure 5.10 Substitution Effects and Income Effects for Two
Normal Goods
(a)
(b)
(c)
Concert
Tickets

Total effect
(+ 1 concert ticket )
B
6
Income A
5
effect
U2
A′
3
Substitution U1
BC2
effect BC1 BC′
0 3 4 5 Basketball
Tickets
Substitution effect Income effect

Total effect (+ 2 basketball tickets)

Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3

Total Effect = Substitution Effect + Income Effect

Isolating the Income Effect

• The change in quantities demanded due to the changes in the
consumer’s purchasing power after the change in prices.
• When the price of basketball tickets decrease, the consumer
can afford to purchase a larger bundle than before.
‒ Represented by the change in the quantity of goods consumed
from bundle A’ (after the substitution effect) to bundle B
‒ Easy calculation: total effect minus the substitution effect
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Three steps to computing substitution and income effects associated
with a price change. Starting with a consumer at an optimal bundle A

1. Draw the new budget constraint and find the new optimal bundle (B )
‒ A price change for one of two goods rotates or pivots the constraint

2. Draw a line parallel to the new budget constraint, but tangent to the old
indifference curve; determine the optimal bundle on the old curve
associated with this theoretical budget constraint (A′ )

3. The substitution effect is the difference in quantities between A and

A′ and the income effect is the difference in quantities between A′
and B
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
What Determines the Size of the Substitution and Income Effects?
1. Curvature: The size of the substitution effect depends on the
curvature of indifference curves
 What does it mean when an indifference curve is relatively
straight?
‒ The 2 goods are relatively substitutable
 Is the substitution effect larger or smaller along a straighter
indifference curve?
‒ Larger, More substitutable = Larger substitution effect

2. Quantity consumed before the price change: The income effect

increases with the amount spent on a good before a price change
 Why does the income effect increase with the amount spent on a
good?
̶ The more you can get from trading off consumption of that good
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Example of the Substitution and Income Effects for an Inferior Good
It is important to see how the income and substitution effects are opposed
to one another with an inferior good.

Consider a consumer choosing bundles of steak and ramen noodles

• Suppose the price of ramen noodles (an inferior good) falls
• Total effect followed by Income and Substitution effects graphically
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Figure 5.12 A Fall in the Price of an Inferior Good
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Figure 5.13 Substitution and Income Effects for an Inferior
Good (a) (b)
(c)
Changes:
Steak
1. Price of ramen noodles has decreased
‒ Sub. Effect positive

2. Relative price of steak has increased

Total effect
‒ Sub. Effect negative (more steak) B
3. Relative Income has increased U2
Income
‒ Income effect positive for steak effect
A
(normal good) and negative for
A′
ramen (inferior good)
Substitution
effect U1
The income effect dominates the
BC1 BC′ BC2
substitution effect for steak
Ramen
Total effect Income noodles
The substitution effect dominates the (more ramen noodles) effect
income effect for ramen noodles.
Substitution effect
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Giffen goods: are goods for which quantity demanded increases
as price rises
• Inferior goods, but the income effect outweighs the substitution effect
• When the price of a Giffen good drops, the substitution effect (which
acts to increase demand) is smaller than the income effect
‒ Results in an upward sloping demand curve!

Economists sometimes question whether Giffen goods actually

exist
• The few examples with humans tend to focus on very poor
households and commodity crops (e.g., rice and potatoes)
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Figure 5.14 A Change in the Price of a Giffen Good
Decomposing Consumer Responses to Price
Changes into Income and Substitution Effects 5.3
Simple Rules about Income and Substitution Effects
The Impact of Changes in Another Good’s
Price: Substitutes and Complements 5.4
A Change in the Price of a Substitute Good
When the price of a substitute good increases, we expect
consumption of the primary good to increase
• Consider Pepsi-Cola and Coca-Cola
 The Impact of Changes in Another Good’s
Price: Substitutes and Complements 5.4
Figure 5.15 When the Price of a Substitute Rises, Demand
Rises
Pepsi
20
At original prices, this consumer purchases 15
A bottles of Pepsi and 5 bottles of Coke
15
U1 When the price of Pepsi doubles, Coke
Pepsi consumption increases by 100% (to 10 bottles),
consumption and Pepsi consumption falls by 67% (to 5 bottles)
falls 10
Coke consumption rose when the price of Pepsi
BC2 U2 BC1
B rose, signify that they are substitutes
5

0
5 10 20 Coke
Coke consumption rises
The Impact of Changes in Another Good’s
Price: Substitutes and Complements 5.4
A Change in the Price of a Complementary Good
When the price of a complement increases, we expect
consumption of the primary good to decrease
• Consider ice cream and hot fudge
 The Impact of Changes in Another Good’s
Price: Substitutes and Complements 5.4
Figure 5.16 When the Price of a Complement
Rises, Demand Decreases
Ice cream
(gallons) At original prices, this consumer
50 purchases 20 tubs of ice cream and
BC1
30 jars of hot fudge.
When the price of ice cream
doubles, consumption of ice cream
falls by 25% (20 to 15 tubs), and
25 BC2 consumption of hot fudge by 33%
Ice cream A
consumption 20 (30 to 20 jars).
falls 15
B U2 U1
Hot fudge consumption decreased
when the price of ice cream
0 increased, signifying that they are
20 30 50 Hot fudge complements.
(quarts)
Hot fudge consumption
falls
The Impact of Changes in Another Good’s
Price: Substitutes and Complements 5.4
A Change in the Price of a Substitutes and Complements
When the price of a substitute good increases, we expect consumption
of the primary good to increase
• Recall the Pepsi-Cola and Coca-Cola example

When the price of a complement increases, we expect consumption of

the primary good to decrease
• Recall the ice cream and hot fudge example

These relationships help to explain the shifts in demand examined

in Chapter 2
The Impact of Changes in Another Good’s
Price: Substitutes and Complements 5.4
Figure 5.17 Changes in the Prices of Substitutes or
Complements Shift the Demand Curve
Combining Individual Demand Curves to
Obtain the Market Demand Curve 5.5
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

Consider the market for wireless speakers

Combining Individual Demand Curves to
Obtain the Market Demand Curve 5.5
Figure 5.19 The Market Demand Curve
(c) (b)
(a)
Price
($/wireless
Speaker set) B
$52

40
A

20

DcousinDmarket =
Dyou Dyou + Dcousin

0 34 6 8 12
Quantity of wireless speaker sets
Combining Individual Demand Curves to
Obtain the Market Demand Curve 5.5
Mathematically connecting the individual and market demand

Qmarket  Qyou  Qcousin  (5  0.05P)  (13  0.25P)

Qmarket  18  0.3P

The difference in choke prices implies your demand function is the market
demand function for prices between $52 (cousin’s choke price) and $100
(your choke price);
• The market demand function applies to prices less than $52

Qmarket  18  0.3P for P  $52

 5  0.5P for P  $52
Conclusion 5.6
This chapter concludes our in-depth analysis of the
consumer side of the supply and demand model. We
• Examined how income and prices affect consumer choices
• Made the link between consumer theory and market demand

In Chapter 6 we begin a parallel in-depth examination of

producer behavior.