CH4new07 - Chapter 4 INDIVIDUAL AND MARKET DEMAND Boiling...

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Chapter 4 INDIVIDUAL AND MARKET DEMAND Boiling Down Chapter 4 The price-consumption curve (PCC) connects all optimal market basket points that result from a series of price changes while nominal income is held constant. The PCC is not widely used in economic analysis, but it does show what is happening to the amount of money the consumer is spending on the good. If the PCC slopes downward, the con- sumer is spending more money overall on the good even though its price fell. If the PCC rises, less money is being spent, and if the PCC is horizontal, the amount of money spent on the good does not change. Because money spent by the consumer is revenue to the producer, a firm would love to know what the PCC of its commodity looks like. Later this issue is approached a different way under the topic of demand elasticity. More interesting for now is the derivation of the individual demand function. By plotting the quantity consumed for each nominal price shown by the budget lines (see Figure 4-1 on the right), the demand curve can be sketched. When the quantity of the good being ana- lyzed is plotted with the absolute level of in- come, an Engel curve results (see Figure 4-3 below). When the amount demanded of a good increases with income, the good is a normal good and the Engel curve is positively sloped. Otherwise, the good is inferior and has a negatively sloped Engel curve. $/yr. 100 10 20 40 80 Shelter Figure 4-1
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CHAPTER 4: Individual and market demand Y($/yr.) a b c X Figure 4-2 Income 3 2 1 a b c X Figure 4-3 Engel Curve Perhaps the most helpful concepts of this chapter are the income and substitution ef- fects of a price change. If you go to a store with a shopping list and find that the price of one of the items has dramatically increased, you usually react in at least two ways. First, you try to purchase less of that item and use something else in its place (the substitution effect). Second, you feel poorer because your income does not reach as far anymore and so you usually economize by buying even less of the item in question (the income effect). Thus a price increase of good X gives you two reasons to reduce your quantity consumed of X. Conversely, if the price of X were to fall, you would have two reasons to buy more of X. Can you intuitively explain these two effects of the price reduction? Graphically, the substitution effect of a price decrease can be shown by rotating the budget line around the original indifference curve until the new price ratio is reached (see Figure 4-4 on the next page). This technique keeps real income (the level of utility) con- stant, but allows the consumer to buy more of the lower-priced good than was originally planned. We must recognize that the budget line that has been created to measure the substitu-
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CH4new07 - Chapter 4 INDIVIDUAL AND MARKET DEMAND Boiling...

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