Managerial

Economics
MBAFT 6103

Today
Theory of Demand

Overview

1. Individual Demand Curves
2. Substitute Goods/ Complementary Goods
3. Normal Goods/Inferior Goods
4. Income Effect and Substitution Effect
5. Constructing Aggregate Demand

Individual Demand Curves

Where do they come from?

An individuals demand curve for good X is derived
by varying Px (and holding everything else constant)
and plotting each new optimal value of X (obtained
by applying the optimal choice rule) against the
corresponding Px. The demand curve is also a
willingness to pay curve.

Individual Demand Curve for X

For each value of Px calculate consumer demand for good x by solving the
consumers utility maximization problem, holding Py and income constant. Plot.

PX

PX = 4

PX = 2
PX = 1
XA

XB

XC

U increasing
X

Individual Demand Curves

Key Points

The consumer is maximizing utility at every point
along the demand curve

The marginal rate of substitution falls along the

demand curve as the price of x falls (if there was an
interior solution).
As the price of x falls, utility increases along the
demand curve.

Demand Curve for good x

How to derive analytically

Algebraically, solve for the individuals demand

using the following equations:
1. pxx + pyy = I
2. MUx/px = MUy/py at a tangency.
Find out the relationship between Px and x which
will give the demand curve for x for constant
value of y and I. Similarly the relation between Py
and y will give the demand curve for y.
(If the second equation does not hold, then check
the corner points where either x = 0 or y = 0.)

Some Denitions
Substitute Goods

An increase in the price of good X leads to an

increase in the consumption of good Y and
vice versa. Examples:
Coke and Pepsi.
Wheat and Barley.

Complementary Goods

An increase in the price of good X leads to a

decrease in the consumption of good Y.
Examples:
DVDs and DVD players.
Computer CPUs and monitors.
Barley and Poultry.

Income Consumption Curve

Definition: The income consumption curve is
the set of optimal baskets for every possible
level of income, holding all the prices
constant.

Engel Curve
The income consumption curve for good x also
can be written as the quantity consumed of good
x for any income level. This is the individuals
Engel Curve for good x. When the income
consumption curve is positively sloped, the slope
of the Engel Curve is positive.

Engel Curve
I ($)
Engel Curve

X is a normal good

92
68
40

10

18

24

X (units)

Some More Denitions

Normal Good

If the consumer purchases more of good x as her

income rises, good x is a normal good.
Equivalently, if the slope of the Engel curve is
positive, the good is a normal good.

Inferior Good
If the consumer purchases less of good x as her
income rises, good x is an inferior good.
Equivalently, if the slope of the Engel curve is
negative, the good is an inferior good.

Price and Demand:

What is the connection?
As the price of x falls, all else constant,
purchasing power rises. This is called the income
effect of a change in price.
The income effect may be positive (normal
good) or negative (inferior good).

Substitution Eect
As the price of x falls, all else constant,
good x becomes cheaper relative to good y.
This change in relative prices alone causes
the consumer to adjust his/ her consumption
basket. This effect is called the substitution
effect.
The substitution effect always is negative.
Usually, a move along a demand curve will
be composed of both effects.

 Income and Substitution Eects

Example 1: Price falls from PX1 to PX2

 Income and Substitution Eects

Example 2: Price falls from PX1 to PX2

Aggregate Demand
The market, or aggregate, demand function is
the horizontal sum of the individual (or
segment) demands.
In other words, market demand is obtained by
adding the quantities demanded by the
individuals (or segments) at each price and
plotting this total quantity for all possible
prices.

Calculating Aggregate Demand

Eg: Two Consumers with Dierent Demands

P

P
Q = 10 - p

Segment 1

Q = 20 - 5p

Q
Segment 2

Calculate aggregate demand function in this market

Calculating Aggregate Demand

Example: Two Consumers with Dierent Demands

P
10

P
Q = 10 - p

Q = 20 - 5p

4
Segment 1

Segment 2

Aggregate demand

 An Important Concept

Network Externality
If one consumer's demand for a good changes
with the number of other consumers who buy
the good, there are network externalities.
If one person's demand increases with the
number of other consumers, then the
externality is positive.
If one person's demand decreases with the
number of other consumers, then the
externality is negative.
Examples: ?

PX

Positive Network Externality

(Bandwagon Eect)
D30: if consumer believe that 30 consumers have access to x
D60: if consumer believe that 60 consumers have access to x

D60
D30

20
10

Pure
Price
Effect

30 38

Market Demand
Bandwagon Effect

60

X (units)

Negative Network Externality

(Snob Eect)
PX
Market Demand
1200
900

D1000
D1300

Snob Effect
Pure Price Effect

1000 1300

1800

X (units)

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Production and Cost