Eaton Micro 6e Ch04

7/27/2019 Eaton Micro 6e Ch04

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2005 Pearson Education Canada Inc.4.1

Chapter 4

More Demand Theory


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The Law of Demand

The law of demandimplies aninverse relationship between priceand quantity demanded.

When the price and quantity of agood are positively related, the goodis called a Giffen Good.


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Figure 4.1 A Giffen good


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Figure 4.2 Income and substitution

effects for a price increase


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Figure 4.3 Income and substitution

effects for a price decrease


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Income and Substitution Effects

If indifference curves are smooth andconvex and if the consumer buys apositive quantity of both goods, then the

substitution effect is always negativelyrelated to the price change.

For a normal good, the income effect isnegatively related to the price change.

For an inferior good, the income effect ispositively related to the price change.


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Compensatory Income

After a price change, the minimumincome that allows the consumer toattain the original indifference curve

is called the compensatory income.

The budget line associated with thecompensatory income is the

compensated budget line.


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Figure 4.4 The nonpositive

substitution effect


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The Compensated Demand Curve

The compensated demand curveidentifies the consumers utilitymaximizing bundle when, as a result

of a price change, the consumersincome is adjusted to keep him/heron the same indifference curve.

The compensated demand curvereflects the substitution effect andcannot be upward sloping.


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Figure 4.5 The compensated demand curve


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Compensating and Equivalent Variation

Equivalent variation identifies thevariation in income that is equivalentto being able to buy good x at a

given price.

Compensating variation identifies thevariation in income that compensates

for the right to buy good x at a givenprice.


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Figure 4.8 Measuring the benefit of a new good


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From Figure 4.8

Mr. Polos non-member initialequilibrium is E0 on I0.

Equilibrium as a member is E1 on I1.

Equivalent variation is EV. With nomembership, this additional incomewould yield indifference curve I1.

Compensating variation is CV. Giventhat he is a member, this reduction inincome yields indifference curve I0.


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Figure 4.9 Measuring the cost of a price change


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From Figure 4.9

Low price of P1 gives equilibrium ofE0 on I0.

Equilibrium with higher price of P1

isat E1 on I1.

With a lower price, reducing incomeby EV yields I1.

With a higher price, increasingincome by CV would yield I0.


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Figure 4.10 The case in which CV equals EV


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Figure 4.11 Consumers surplus for a new good


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Figure 4.12 Consumers surplus

for a price reduction


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Figure 4.13 Marginal values and

marginal rates of substitution


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Figure 4.14 Total value and marginal value


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Figure 4.15 Equal marginal values


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Application: Two Part Tariff

What combination of camera price(pc) and film price (p1) maximizeprofits?

Cost of producing camera is $5, costof making film is 1$.

The firms profit maximizing strategy

is to sell the film at cost and chargethe corresponding reservation pricefor the camera, area GAF (Fig 4.16).


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Figure 4.16 The Polaroid pricing problem


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Figure 4.17 The Paasche quantity index


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Paasche Quantity Index

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Laspeyres Quantity Index

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Price Indices

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Figure 4.18 An index-number puzzle

Eaton Micro 6e Ch04

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