ECON 224 SU Equilibrium in Competitive Markets and Monopolies Essay

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ECON224 Assignment for Overseas Students.
You have 24 hours to complete and submit this assignment. Work must be uploaded to Moodle by
1pm (GMT) on 11th December 2021.
Choose ONE question
1. With the aid of appropriate diagrams, show how a firm’s supply curves are derived using
an expansion path in: i), the short-run; and ii), the long-run. Explain why the answers to
i) and ii) differ. What are the implications for the firm?
2. Compare and contrast long-run equilibrium in a competitive market with that in a
market characterised by monopoly and their respective implications for consumer and
producer surpluses.
Econ 224: Introduction to Economics for
Managers
Course Delivery
The lecture programme is face-to-face until further notice.
Those students not yet arrived in Lancaster have access to a
recording posted on Moodle. Lectures are supported by a
weekly face-to-face seminar per (Weeks 2 – 9). Those students
who have not yet arrived in Lancaster have a designated online seminar (see your timetable).
Supporting Lecture slides will also be available on Moodle (in
advance) as will seminar worksheets and suggested solutions.
Course Lecturer
Weeks 1-10: Dr Robert Read, LUMS B13 (r.read@lancaster.ac.uk).
Econ 224: Introduction to Economics for
Managers
Course Textbook
G. Mankiw, M. Taylor & A. Ashwin, Business Economics or
Microeconomics.
Note that the first text also includes Macroeconomics at not
much greater cost and may support (not guaranteed) Econ
225 in Lent Term. There is also one called Economics as well
just to confuse. Older editions are ok but beware changes in
the order of content, different page numbers and questions.
The course text is also supported by the customised on-line
MindTap resource from the publishers (can be purchased at
the same time as the text from the University Bookshop). This
includes additional material, self-assessment tools, quizzes etc.
Econ 224: Introduction to Economics for
Managers – Seminars
These are designed to:
•
Explore selected issues from the lectures in greater
depth.
•
Work through set problems from question papers on
Moodle (see the course paper – also on Moodle).
•
Deal with questions and issues relating to the course
material.
Reminder: Seminars are compulsory. Poor attendance/not
doing the worksheets is highly correlated with poor course
performance (i.e., don’t make plans for August!).
Econ 224: Introduction to Economics for
Managers – Student Questions
If you have problems with the Econ 224 material:
• Ask questions in the seminars or afterwards.
• e-mail your Tutor.
• e-mail me – r.read@lancaster.ac.uk.
• Arrange an appointment with your Tutor (there may
be specified Office Hours).
It is our objective is to do what we can to ensure that you
all gain a good pass in this course – even if you don’t
come to love Economics or start with no desire to love it!
Econ 224: Introduction to Economics for
Managers
Prior courses in Economics
Some students may have taken a prior course in
Economics – e.g., ‘A’ level, Baccalaureate, etc.
This is not necessarily an advantage! This course follows its
own curriculum: the Economic concepts are always the
same but the approach, method, depth and means of
analysis may differ to previous experience. Please do not
assume that you know it all…
Choice & Resource Allocation
Under Scarcity
Econ 224: Lecture 1, Michaelmas 2021-2022
Dr Robert Read
Econ 224: Economics for Managers
Choice & Resource Allocation Under
Scarcity
1. Constrained Optimisation.
2. The Budget Constraint.
3. Opportunity Cost & Indifference Curves.
4. Optimising Consumption.
5. Normal & Inferior Goods.
6. The Income & Substitution Effects.
Part 1. Constrained Optimisation
What is Economics?
Constrained Optimisation
The objective of the course is to provide students
following business-related degrees to gain a good
understanding of the behaviour of consumers and firms
along with policies introduced by government. It
examines
how
consumers,
firms,
markets
and
governments engage in optimising behaviour (i.e., how
do they make decisions?).
What is Economics?
Constrained Optimisation
•
•
•
•
Consumers want to maximise their satisfaction or
happiness (‘utility’).
Firms want to maximise their profits and minimise their
costs (be efficient).
Markets determine the level of competition between
firms and therefore outputs and prices.
Governments might want to maximise social benefit
(‘welfare’) or taxation while minimising waste and
damage to the environment (well, many do).
Constrained Optimisation
Economics is really about analysing issues of constrained
optimisation – i.e., choice.
If money, resources etc. are limited, how do individuals,
firms and governments choose between different
options?
Constrained Optimisation
For example, maximising consumer utility subject to a key
constraint – i.e., income, a notable challenge for students.
•
•
These constraints are normally fixed (i.e., you have a
budget), so the focus of analysis is to optimise your
behaviour given this constraint.
The constraints can then be relaxed to see how
behaviour changes.
If you can learn how to think like an Economist (!), you
should be able to apply relevant analytical tools to
understand, tackle and solve everyday problems in
consumption, production and business – i.e., ‘real life’.
Constrained Optimisation: Problems
Optimisation is not always easy however…
…too little information.
…neglected information.
In addition, beliefs are not unbiased.
Microeconomic theory needs to be used… as a starting
point for more realistic models.
Is Economics a perfect representation of reality?
No way! but it certainly helps to understand how people,
firms, markets and governments behave.
Part 2. The Budget Constraint
(Money or the lack of it)
Consumer Choice: the Budget Constraint
Most consumers have limited money – especially students.
This gives rise to issues of choice under scarcity:
• It is not possible to increase consumption of one good
without reducing the consumption of at least one
other (beer vs pizza, textbook vs night out etc.).
• Total consumption is limited by the resources available
– income (the budget constraint).
This challenge applies to many every-day decisions that
individuals, firms and governments have to make.
The Budget Constraint
The budget constraint simply indicates what any
consumer can afford to spend; the greater the budget,
the greater will be the expected consumption of most
goods and services.
How can we analyse the budget constraint?
The Budget Constraint
This can be done by analysing the choice between two
goods or services (e.g., x and y), where x is the one that
we are interested in and y can be just another good or
service, several or all others. For this part of the analysis, x
and y are just two different goods.
An individual’s consumption therefore comprises some
combination of x and y:
c = f (x, y)
The Budget Constraint
Suppose that the consumption choice is a simply one
between just two goods: pizza and baked beans.
The cost of (frozen) pizza is £2.00 and a pack of 4 cans of
baked beans £1.00. The weekly food budget is £20.
Given this budget constraint for food, if all the money is
spent on pizza, a student can buy a maximum of 10 pizzas
per week while if it is all spent baked beans, then they
can buy a maximum of 80 tins of baked beans.
The Budget Constraint
A diet of just pizza or just baked beans is probably not a
good thing or likely until near the end of term. The
likelihood is that a student would actually want to buy
some combination of pizza and baked beans (and other
things).
To have more of pizza, a student would have to give up
consumption of some baked beans. Given the price
relationship; this would be one pizza for two packs of
baked beans. This relationship can be expressed as the
slope of the Budget Constraint.
The Budget Constraint
Once we know this price relationship – one pizza equals
two packs of baked beans – It is possible to construct a
Budget Line. This shows all of the possible combinations of
pizza and cans of baked beans in terms of either price p
or quantity q.
Price:
-px / py
=>
-ppizza / 0.5baked beans
=>
-2qbaked beans / qpizza
or Quantity:
-qy / qx
The Budget Constraint
Baked
Beans (y)
The slope of the budget line is the
relative price of the two goods – one
pizza per two packs of baked beans.
30 @
£1.00
Slope (p) = -p / 0.5bb
Slope (q) = -2qbb / qp
0
15 @
£2.00
Pizzas (x)
The Budget Constraint
How do we decide what combination of pizza and
baked beans to consume?
That depends upon our preferences…
Some people like pizza more than baked beans and
others baked beans more than pizza – so individuals will
choose different combinations – to be discussed shortly.
Changes to the Budget Constraint:
A Change in Income
What happens if the budget constraint changes – that is,
we have more or less money to spend?
A change in Income shifts the budget line outwards (a rise
in Income) or inwards (a fall in Income) parallel to the
origin. There is no change in its slope since prices have not
changed.
Individuals can therefore afford to consume more baked
beans and pizza if income rises and consume less if
income falls.
The Budget Constraint
Baked
Beans (y)
A rise in income to £36 shifts the
budget line upwards and increases the
maximum possible consumption of
both baked beans and pizza.
36
30
Slope (p) = -p / 0.5bb
Slope (q) = -2qbb / qp
0
15
18
Pizzas (x)
The Budget Constraint
Baked
Beans (y)
A fall in income to £20 shifts the budget
line downwards and reduces the
maximum possible consumption of
both baked beans and pizza.
30
Slope (p) = -p / 0.5bb
Slope (q) = -2qbb / qp
20
0
10
15
Pizzas (x)
Changes to the Budget Constraint:
A Change in Price
A change in the price of either good however, alters the
slope of the budget line since the relative price of baked
beans and pizza has changed.
If the price of a pizza falls to £1.50p, it is now possible to
buy a maximum of 20 with the same budget (£30).
The slope of the budget line changes to:
-p / 0.66bb
-1.5bb / p
or:
The Budget Constraint
Baked
Beans (y)
If the price of a pizza falls to £1.50, the
Budget Line will pivot outwards from
the y-axis since the maximum possible
consumption of pizza has increased
from 15 to 20.
30
New slope = -0.66bb / p
or -1.5bb / p
0
15
20
Pizzas (x)
Changes to the Budget Constraint:
A Change in Price
For any new price relationship, consumption is expected
to increase for the good which had a relative price fall.
Consumption however, will fall for the other good (its price
remains unchanged but has increased relative to the
other good).
This is the Substitution Effect – the change in consumption
of y when the price of x good changes.
By how much will consumption of each good therefore
change? That is determined by consumers’ preferences.
Part 3. Opportunity Cost & Indifference
Curves
Preferences: Utility & Indifference Curves
The budget constraint tells us absolutely nothing about
consumer preferences. Students (consumers) generally
have similar incomes but that does not mean that they
necessarily consume the same combinations of goods
and services (e.g., pizza and baked beans).
This depends upon their tastes.
Preferences: Utility & Indifference Curves
Consumers usually want to maximise their own satisfaction
or happiness – (‘utility’ in economics-speak).
To do this, they will consume goods and services, e.g.,
baked beans and pizza or x and y, in their own personal
preferred combination. This can be expressed as:
U = f (x, y)
Where utility, U, is some function of x and y.
Preferences: Utility & Indifference Curves
The personal preferences of consumers can be analysed
with reference to Utility using Indifference Curves.
An Indifference Curve shows all combinations of x and y
for which a consumer’s has exactly the same utility; i.e., it
is constant. This means that, at any point along the same
Indifference Curve, a consumer is equally happy/satisfied.
For the purposes of this analysis, x can be a specific good,
e.g., chocolate, y can represent all other possible goods.
Choice & Opportunity Cost
The concept of Opportunity Cost is extremely important in
the economic analysis of choice. Opportunity Cost is the
cost of choosing one activity or expenditure relative to
another, when choice is constrained. When choosing
what to consume, consumers must sacrifice one good in
order to consume another (e.g., pizza versus baked
beans). The Opportunity Cost of choosing pizza is not
consuming baked beans.
The Opportunity Cost is therefore the benefit foregone by
not choosing the alternative. The objective of individuals,
firms etc. is therefore try to minimise the total Opportunity
Cost of their choices.
Utility & Indifference Curves
Focusing on individual preferences, we know that
consumers have different tastes. This means that each
consumer has their own valuation of Opportunity Cost for
any given choice.
It is possible to represent the preferences of any individual
consumer and their Opportunity Cost valuations using
Indifference Curves. These illustrate the trade-off that any
consumer is willing to make in choosing between two
goods x and y – i.e., their respective Opportunity Cost.
For some combinations of x and y, utility (and therefore
Opportunity Cost) must be constant – and can be
represented by an Indifference Curve.
An Indifference Curve
y
An Indifference Curve is a locus of
points of equal utility gained by
consuming different combinations of
x and y.
I
0
x
Utility & Indifference Curves
Indifference Curves have several important properties:
• They are downward sloping – some of good y must be
sacrificed to consume more of good x.
• They are convex (bowed) to the origin – the
relationship is generally non-linear; the amount of good
y that must be sacrificed to consume more of good x is
not constant.
The Indifference Curve
I0 is a line of equal indifference:
combinations, x1, y1 give a consumer
exactly the same utility as x2, y2.
y
y1
y2
I0
0
x1
x2
x
Utility & Indifference Curves
Indifference Curves have several important properties:
• They are downward sloping – some of good y must be
sacrificed to consume more of good x.
• They are convex (bowed) to the origin – the
relationship is generally non-linear; the amount of good
y that must be sacrificed to consume more of good x is
not constant.
• Consumers want to be on the highest possible
Indifference Curve since it represents the greatest utility
or satisfaction; I1 is preferable to I0 : U [ I1 ] > U [ I0 ]
An Indifference Map
Every combination of x and y on I1
gives greater utility than any
combination of x and y on I0.
y
y1
y2
I1
I0
0
x1
x2
x
Utility & Indifference Curves
Each consumer has their own set of Indifference Maps.
Indifference Curves have several important properties:
• They are downward sloping – some of good y must be
sacrificed to consume more of good x.
• They are convex (bowed) to the origin – the
relationship is generally non-linear; the amount of good
y that must be sacrificed to consume more of good x is
not constant.
• Consumers want to be on the highest possible
Indifference Curve since it represents the greatest utility
or satisfaction; I1 is preferable to I0 : U [ I1 ] > U [ I0 ]
• Indifference Curves cannot cross (transitivity).
A Logically Impossible Indifference Map
A consumer is indifferent between A and
B and also between points B and C.
But, A and C have different levels of
utility – a logical impossibility.
y
C
A
B
I0
I1
0
x
The Slope of the Indifference Curve
The slope of the Indifference Curve is determined by the
willingness (i.e., the Opportunity Cost) of a consumer to
give up units of x so as to be able to consume more y and
vice versa.
This is referred to as the Marginal Rate of Substitution
between x and y, MRSxy.
This is the rate at which a consumer is willing to sacrifice
consumption of one good for the other.
The Slope of the Indifference Curve
A consumer is willing to give up
(y1 -> y2) so as to gain (x1 -> x2).
y
y1
y2
I0
0
x1
x2
x
The Slope of the Indifference Curve
Note that the Marginal Rate of Substitution between x
and y changes along the Indifference Curve.
Each additional unit of y sacrificed requires compensation
in terms of more units gained of x. The opposite is also
true. The Opportunity Cost of sacrificing y for x therefore
also changes.
Diminishing Marginal Utility
The change in the willingness to trade x for y and y for x is
know as Diminishing Marginal Utility. Increased
consumption of good x increases the Opportunity Cost of
not consuming good y and vice versa.
For example; however much you like chocolate relative
to water, at some point if you keep eating more
chocolate, you will start to value a drink of water more
than eating an additional chocolate!
The Slope of the Indifference Curve
A consumer is willing to give up
(y1 – y2) so as to gain (x1 – x2).
y
y1
y2
I0
0
x1
x2
x
The Slope of the Indifference Curve
To gain (x2 – x3 ) however, they
would only be willing to give up
(y2 – y3).
y
y1
y2
I0
y3
0
x1
x2
x3
x
Marginal Utility
Recall, utility is:
U = f (x, y)
Marginal utility is the rate of change of utility as the
consumption of a good changes. How much does utility
rise when consumption of x or y increases ?
MUx = dU / dx = fx
MUy = dU / dy = fy
Marginal Utility
For any Indifference Curve:
dU = 0
Such that:
dU = fx dx + fy dy = 0
=>
=>
fy dy = – fx dx
dy / dx = fx / fy
The slope of the Indifference curve is: dy / dx
The change in utility (Marginal Utility) of y wrt x.
Diminishing Marginal Utility
The slope of the Indifference Curve is therefore convex to
the origin because of Diminishing Marginal Utility. The
more that you have of good y, the more of y that you are
willing to give up to gain more of good x while leaving
total utility unchanged.
dy / dx = MRSxy =
– MUx / MUy
Diminishing Marginal Utility
Diminishing Marginal Utility has broader implications than
just affecting the slope of Indifference Curves. It is an
important characteristic of consumption generally.
The more units of a good consumed, the lower the
marginal utility derived from it by a consumer. The greater
the quantity of x relative to y, the lower the value of each
additional unit of x relative to y.
Indifference Curves: Perfect Substitutes
Not all Indifference Curves have curved slopes.
Perfect substitutes are always traded like-for-like so that
the utility from one is always equal to that of the other;
e.g., 50p pieces and £1 coins. The Indifference Curves
must be straight lines because the rate of exchange
remains constant.
Indifference Curves: Perfect Substitutes
If x and y are perfect substitutes, then they
will be traded ‘like-for-like’ – hence straight
line Indifference Curves.
y
300
200
100
I0
0
100
I1
200
I2
300
x
Indifference Curves:
Perfect Complements
These are consumed in proportion to each other so that
additional units of one good without the other do not
increase consumer utility; e.g., left and right shoes (for
those with two feet – not both left ones). The Indifference
Curves must be rectangular since the two goods are
consumed in proportion.
Indifference Curves:
Perfect Complements
If x and y are perfect complements,
then they will be need to be consumed
in strict proportion – hence rectangular
Indifference Curves.
y
3a
I2
2a
I1
a
I0
0
b
2b
3b
x
Part 4. Optimising Consumption
Optimising Consumption
It is now possible to complete the analysis of consumption
by putting the Budget Line and Indifference Curve
analyses together.
This requires the ratio of relative prices of x, y to be equal
to the Marginal Rate of Substitution between them:
px / py = MRSxy
This must be where the furthest Indifference Curve from
the origin is just tangential to the budget line, such that x0,
y0 is the optimal quantity and combination consumed.
Optimal Consumption
Optimal consumption is where the
slope of the budget line px / py is
equal (i.e., tangential) to the slope
of the Indifference Curve MRSxy.
y
y0
I0
0
x0
x
Optimal Consumption
If a consumer’s income rises, their budget line shifts
outwards and will be tangential to a new Indifference
Curve, I1. This curve is in the same ‘family’ of Indifference
Curves as I0 – i.e., the MRS is constant – so that
consumption of both x and y will increase.
Optimal Consumption
As the budget line shifts outwards, it
is tangential to a higher Indifference
Curve, I1.
y
y1
y0
I1
I0
0
x0
x1
x
Optimal Consumption
If a consumer’s income rises, their budget line shifts
outwards and will be tangential to a new Indifference
Curve, I1. This curve is in the same ‘family’ of Indifference
Curves as I0 – i.e., the MRS is constant – so that
consumption of both x and y will increase.
A rise in income therefore increases consumer utility by
enabling the consumption of more of both goods x and y
(x1, y1).
Part 5. Normal & Inferior Goods
Normal Goods
So far, a rise in a consumer’s income has increased the
consumption of all goods and a fall in income has led to
reduced consumption of all goods. This is the ‘Income
Effect’, which is positively related to the consumption of all
goods x and y.
This is true for Normal goods; more of them are consumed
at higher levels of income and fewer at lower levels of
income. Most goods and services are ‘normal’.
It is possible to plot the consumption of a good (x) against
different levels of income (Y) to show how its consumption
varies with income – an Engel Curve.
The Engel Curve for a Normal Good
Income,
Y,
As Income, Y, rises, consumption of x
rises – x must be a Normal good.
Y3
Y2
Y1
0
x1
x2
x3
x
Inferior Goods
For some goods however, an increase in Income actually
leads to lower consumption – these are Inferior goods.
These are usually staples – as in student diets – bread,
pasta, potatoes, rice, baked beans etc…
People on lower incomes are therefore likely to consume
more Inferior goods. As their Income rises – e.g., students
getting jobs – their consumption of Inferior goods will fall.
The Engel Curve for an Inferior Good
Income,
Y,
As Income, Y, rises, consumption of x
falls – x is an Inferior good.
Y3
Y2
Y1
0
x3
x2
x1
x
The Engel Curve of an Inferior Good
Income,
Y,
In some cases of an Inferior
good, as Income, Y, rises,
consumption of x first rises then
falls. So, at very low incomes,
the good appears Normal but
later becomes Inferior!
Y3
Y2
Y1
0
x3
x1
x2
x
‘Giffen’ Goods
Giffen Goods are an extreme case of Inferior Goods for
which few if any substitutes exist.
They can be defined as goods for which the Income
Effect of a price rise is greater than the Substitution Effect.
If the price of an Inferior Good rises, the Substitution Effect
will be negative – buy less – but the Income Effect is
positive – buy more. In the case of a Giffen Good, the
latter effect is greater than the former so that
consumption actually increases!
Conspicuous Consumption:
Veblen Goods
More than a century ago, the economist Thorstein Veblen
coined the term conspicuous consumption to refer to
goods which are viewed by consumers as high quality,
luxury and exclusive. Diamonds, Rolls-Royce cars, Rolex
watches, some champagne brands (Cristal) and designer
brands (e.g., the Hermès Birkin handbag).
These are not Giffen Goods but their ‘snob’ appeal
means that their prices are inversely related to
consumption – the higher the price, the greater the desire
to consume. If too many people buy a Veblen good, it
loses its exclusivity and its demand falls!
Part 6. Income & Substitution Effects
The Income Effect
The Income Effect has already been discussed with
regard to changes in the Budget Line, where there is a
change in absolute or relative Income.
The Budget Line moves outwards or inwards in parallel
since relative prices remain constant, leading to a shift to
a different (higher or lower) Indifference Curve.
The Substitution Effect
The Substitution Effect occurs when the price of a good, x,
changes such that the slope of the Budget Line also
changes. This was shown briefly earlier.
Any change in absolute or relative prices between two
goods, x and y, means that the optimum position on the
MRSxy must also change. This is because there has been a
shift along an Indifference Curve since the Opportunity
Cost has changed.
Showing the Income & Substitution Effects
It is possible to illustrate and quantify the Income and
Substitution Effects in a single diagram.
The ‘simplest’ way to do this is to demonstrate what
happens when the price of a single good, x, falls while the
prices of all other goods, y, remain constant.
This requires a little graphical manipulation and leads to
possibly slightly different results depending upon how it is
drawn.
The Income & Substitution Effects
The Budget Line is now tangential to
a higher Indifference Curve, I1.
y
I0
y0
I1
I0
0
x0
x
The Income & Substitution Effects
Consumption of both x and y has
increased (to x1, y1).
y
y1
y0
I1
I0
0
x0
x1
x
The Income & Substitution Effects
A change in the price of a Normal good (a fall or rise) has
two effects:
The Income Effect
A fall (rise) in the price of a good increases (reduces)
relative income so that a consumer can afford to buy
more (less) of both goods.
The Substitution Effect
A fall (rise) in the price of one good makes it relatively
cheaper (expensive). A consumer will therefore buy more
(less) of the cheaper (expensive) good and less (more) of
the more expensive (cheaper) one.
The Magnitudes of the Income &
Substitution Effects
However, the overall effect of a price change of one
good on all goods is not known.
In all cases, the impact on the good with the price
change (x) is known – if its price falls, consumption
increases, if its price rises, consumption falls. This is not the
case with the other good whose price has not changed
(y). In the example shown, the fall in the price of x
increases the consumption of both x and y.
It is therefore important to disaggregate the overall effect
into the specific Income and Substitution Effects.
The Magnitude of the Substitution Effect
I1
The Substitution Effect is shown by
drawing the new Budget Line parallel
to the original Indifference Curve. It is
seen in the move along I0.
y
I0
y0
I1
I0
0
x0
x
The Magnitude of the Substitution Effect
To measure the Substitution Effect of a price change, the
new Budget Line is drawn parallel with the original
Indifference Curve at the new combination of x and y
(the MRS is different). This shows the shift along the
Indifference Curve and so separates this from the Income
Effect. The change in consumption of x (x0 to x’) and y (y0
to y’) is the Substitution Effect.
For Normal Goods, consumption of the good whose price
has fallen (x) will rise and consumption of the good whose
relative price has risen (y) will fall.
The Magnitude of the Substitution Effect
I1
The Substitution Effect is shown by
the parallel shift of the new budget
line tangential to the original
Indifference Curve. It is seen in the
move along I0. Consumption of x
rises (x0 to x’) while y falls (y0 to y’).
y
I0
y0

I1
I0
0
x0 x’
x
The Magnitude of the Income Effect
The Income Effect of a price change is shown by
comparing the difference in consumption between the
two tangential points for the Substitution Effect and the
combined Substitution and Income Effects (the residual
must be the Income Effect). This is the shift between
Indifference Curves.
The Income Effect is therefore the change in consumption
of x from x’ to x1 and y from y’ to y1. For Normal Goods, a
rise in (relative) income leads to a rise in consumption of
both goods.
The Magnitude of the Income Effect
I1
The Income Effect is shown by the shift
from the new tangency on the original
Budget Line on I0 (x’, y’ – Substitution
Effect) to the same tangency on the
new Budget Line I1.
y
I0

I1
I0
0

x
The Magnitude of the Income Effect
I1
In this case, consumption of x rose (x’
to x1) and y rose (y’ to y1). The Income
Effect here is therefore positive in both
cases
y
I0
.
y1

I1
I0
0

x1
x
The Magnitudes of the Income &
Substitution Effects
The impact of the fall in price of x on the consumption of x
and y is as expected for Normal Goods:
Good x:
Income Effect
Substitution Effect
Overall effect
+ve (x’ to x1)
+ve (x0 to x’)
+ve (x0 to x1)
Good y:
Income Effect
Substitution Effect
Overall effect
+ve (y’ to y1)
-ve (y0 to y’)
?
(y0 to y1)
Determinants of Demand &
Demand Elasticities
Econ 224: Week 2 Lecture, Michaelmas 2021-22
Dr Robert Read
Econ 224: Introduction to Economics for Managers
Determinants of Demand &
Demand Elasticities
1.
2.
3.
4.
The Determinants of Demand
The (Own) Price Elasticity of Demand
The Income Elasticity of Demand
Cross-Price Elasticity of Demand
Part 1: The Determinants of Demand
What is Demand?
The Quantity Demanded
The amount of a good or service that consumers are
willing to purchase.
The ‘Law’ of Demand
That the quantity demanded of a good or service will fall
when its price rises and rise when its price falls – ceteris
paribus – other things being equal. Exceptions include
Veblen Goods (luxuries) and Giffen Goods (very inferior
goods).
Deriving a Demand Curve
The tools introduced in Lecture 1 can be used to derive
a Demand curve for a consumer.
Using the Budget Line and Indifference Curves, it is
possible to plot a consumer’s preference for good x at
each and every price – keeping the price of y (i.e., all
other goods and services) constant.
Deriving a Demand Curve
y
As the price of x falls, so the budget line
rotates to give a new higher level of
maximum consumption of x. This is
tangential to a new Indifference Curve I1.
I1
I0
0
x
Deriving a Demand Curve
y
As the price of x continues to fall, so the
budget line rotates to give new higher levels
of maximum consumption of x. This is
tangential to new Indifference Curves I1, I2.
I2
I1
I0
0
x
Deriving a Demand Curve
y
For example:
px0 = 40, qx0 = 24
px1 = 30, qx1 = 50
px2 = 20, qx2 = 70
I2
I1
I0
0
x0 = 24
x1 = 50
x2 = 70
x
Deriving a Demand Curve
All of these different price-quantity combinations of x can
then be transposed into (px, qx) space by plotting price
(px) against its quantity (qx). This gives the Demand Curve
for x.
Remember: the prices of all other goods (y) must remain
constant.
Deriving a Demand Curve
p
This is the Demand Curve
derived from the earlier
Indifference Curve analysis.
40
30
20
D
0
24
50
70
q
The Demand Curve
The Demand Curve shows the relationship between the
price and quantity of a good or service and plots all of
the possible combinations of p and q.
The Demand Curve is generally downward sloping to the
right, such that price and quantity are inversely related –
as in the ‘Law’ of Demand.
The Market Demand Curve
From the individual Demand Curve that has been
derived, it is possible to produce a Market Demand
Curve. This is obtained by adding the quantity
demanded by every consumer for each price – in other
words, it represents the sum of all of the individual
Demand Curves.
More generally, the Demand Curves of every individual
can be summed horizontally to obtain the Market
Demand Curve (i.e., Sqx * n, where n is the population).
The Market Demand Curve
Individual Demand curves are summed horizontally to
derive the Market Demand curve.
Consumer 1
Price
Consumer 2
Price
x1
Quantity
Market = Consumers 1+2
Price
x2
Quantity
x1+x2
Quantity
Changes to the Demand Curve
A Demand Curve may change in two important ways:
• A change in the price of the product x. This leads to a
movement along the Demand Curve for x.
• A change in one or more other determinants. This
leads to a shift of the Demand Curve for x (including a
possible change in its slope).
Effect of a Price Change On Demand
p
£2.00
On hot days, ice cream sellers
may raise their prices (from
£1.50 to £2.00). This results in
a shift along the Demand
Curve (from A to B) and a fall
in Demand from 250 to 200.
B
A
£1.50
D
0
200
250
q
The Demand Curve: Non-Price
Determinants
The derivation of the Demand Curve is based upon
several critical assumptions (hence, ceteris paribus –
everything remains constant):
•
•
•
•
•
The number of consumers is constant.
Incomes are constant.
The prices of all other goods are constant.
Tastes are constant.
Expectations are consistent and stable.
Qdx = f (px, Y, psubstitutes,, pcomplements, T, Exp, etc.)
Changes in the Demand Curve:
Non-Price Determinants
The Demand Curve will therefore shift outwards to the
right if:
• There is an increase in the number of consumers.