# Chapter 04 - 15.03.2011 Chapter 4 Demand I have enough...

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15.03.2011 1 Chapter 4 Demand I have enough money to last me the rest of my life, unless I buy something. Jackie Mason ECON201 - Spring 2011 4-2 Chapter 4 Outline 4.1 Deriving Demand Curves 4.2 Effects of an Increase in Income 4.3 Effects of a Price Increase 4.4 Cost-of-Living Adjustment 4.5 Revealed Preference ECON201 - Spring 2011 4-3 4.1 Deriving Demand Curves If we hold people’s tastes, their incomes, and the prices of other goods constant, a change in the price of a good will cause a movement along the demand curve . We saw this in Chapter 2:

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15.03.2011 2 ECON201 - Spring 2011 4-4 4.1 Deriving Demand Curves In Chapter 3, we used calculus to maximize consumer utility subject to a budget constraint. This amounts to solving for the consumer’s system of demand functions for the goods. Example: q 1 = pizza and q 2 = burritos Demand functions express these quantities in terms of the prices of both goods and income: Given a specific utility function, we can find closed- form solutions for the demand functions. ECON201 - Spring 2011 4-5 4.1 Example: Deriving Demand Curves Constant Elasticity of Substitution (CES) utility function: Budget constraint: Y= p1q1 + p2q2 In Chapter 3, we learned that the demand functions that result from this constrained optimization problem are: Quantity demanded of each good is a function of the prices of both goods and income. ECON201 - Spring 2011 4-6 4.1 Example: Deriving Demand Curves Cobb-Douglas utility function: U(q1, q2) = q1a q2(1-a) Budget constraint: Y= p1q1 + p2q2 In Chapter 3, we learned that the demand functions that result from this constrained optimization problem are: With Cobb-Douglas, quantity demanded of each good is a function of only the good’s own-price and income.
15.03.2011 3 ECON201 - Spring 2011 4-7 4.1 Deriving Demand Curves • Panel a below shows the demand curve for q 1 , which we plot by holding Y fixed and varying p 1 . ECON201 - Spring 2011 4-8 4.1 Deriving Demand Curves Graphically Allowing the price of the good on the x-axis to fall, the budget constraint rotates out and shows how the optimal quantity of the x-axis good purchased increases. This traces out points along the demand curve. ECON201 - Spring 2011 4-9 4.2 Effects of an Increase in Income • An increase in an individual’s income, holding tastes and prices constant, causes a shift of the demand curve . An increase in income causes an increase in demand (e.g. a parallel shift away from the origin) if the good is a normal good and a decrease in demand (e.g. parallel shift toward the origin) if the good is inferior . • A change in income prompts the consumer to choose a new optimal bundle. • The result of the change in income and the new utility maximizing choice can be depicted three different ways.

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15.03.2011 4 ECON201 - Spring 2011 4-10 4.2 Effects of an Increase in Income ECON201 - Spring 2011 4-11 4.2 Effects of an Increase in Income • The result of the change in income and the new utility maximizing choice can be depicted three different ways.
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Chapter 04 - 15.03.2011 Chapter 4 Demand I have enough...

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