Professor Jay Bhattacharya

Spring 2001

Example: Calculating IEPs and

Engel Curves

Demand II

Find the IEP and Engel Curve for a consumer

with

Recap: last lecture we covered:

Income Expansion Paths and Engel curves
Inferior and Normal Goods
Necessities and Luxuries
Marshallian Demand Curves

Spring 2001

Econ 11-Lecture 6

Cobb Douglass Utility Function : U ( x, y ) = x y1

Budget Constraint : px x + p y y = I

To find the solution:

Solve for the Marshallian demand curves. This will
automatically give you the Engel Curve
Solve each demand curve for income
Set these equations equal to each other to derive the
IEP.
1

Spring 2001

Solved Example

Find the Marshallian demand curves:

L = x y1 ( p x x + p y y I )

x( px , p y , I ) =

Calculate the first order conditions:

p x = 0

Spring 2001

x
L
= p y = 0
y
y

Econ 11-Lecture 6

Solved Example (III)

px x*

I=

y ( p x , p y , I ) = (1 )

I
py

Spring 2001

Econ 11-Lecture 6

What happens to demand when price

changes?

Solve each demand curve for income:

I=

I
px

These demand curves are the same as the Engel

curves, since they show how the optimal levels of
x and y change with income.
Note that for Cobb-Douglass utility, Engel curves
are linear in income.

L
= px x + p y y I = 0

Solved Example (II)

Set up the Lagrangian:

L
y
=
x
x

Econ 11-Lecture 6

x2

p y y*
1

Setting these equations equal to each other

gives the income expansion path:
py y*
1

(1 ) p x x*
px x*
y* =

p y

slope =

slope =

For Cobb-Douglass utility, the IEP is linear.

*
1

p
p2

p10
p2

x1
Spring 2001

Econ 11--Lecture 6

Econ 11-Lecture 6

Spring 2001

Econ 11-Lecture 6

Professor Jay Bhattacharya

Spring 2001

Marshallian Demand Curve

What Causes the Change in

Demand?

p1

2 reasons why demand for x1 changes

p1*

it is more expensive relative to x2

consumer effectively has less income

We label these 2 effects as:

p10

the substitution effect

(Hicks substitution effect)

the income effect

x1
Spring 2001

Econ 11-Lecture 6

The Hicks Substitution Effect

Spring 2001

Econ 11-Lecture 6

The Hicks Income Effect

x2

x2
The budget constraint
tilts along the original
utility curve until its
slope reflects the new
relative prices.

Then the tilted budget

constraint shifts back to
reflect the new budget
constraint.

x1
Spring 2001

Econ 11-Lecture 6

x1
9

The substitution effect must be negative

The income effect can be positive or
negative. Why?

Spring 2001

Econ 11-Lecture 6

10

Hicks vs. Slutsky

The Hicks substitution effect holds utility
constant

some goods are inferior

rotate along the indifference curve

The Slutsky substitution effect holds

purchasing power constant
rotate around the original consumption bundle

Its easier to derive the Slutsky equation and

the size of the income effect from the latter
x1 inferior
Spring 2001

Econ 11--Lecture 6

x1 normal
Econ 11-Lecture 6

11

Spring 2001

Econ 11-Lecture 6

12

Professor Jay Bhattacharya

Spring 2001

The Slutsky Substitution Effect

x2

The Slutsky Income Effect

x2

x1
Spring 2001

Econ 11-Lecture 6

x1
13

(+ or -)
Income Effect

1 = 1 + 1

The size of the substitution effect depends upon how

much of a change is needed to get to the point where
the MRS is equal to the slope of the new budget
constraint.

( -)
Substitution Effect

This distance depends upon the curvature of the

indifference curve.

If the indifference curve is flat, the substitution effect

will be large.
If the indifference curve is very convex, the
substitution effect will be small.

The Slutsky Equation

Spring 2001

Econ 11-Lecture 6

15

Spring 2001

Econ 11-Lecture 6

16

How large is the income effect?

How large is the substitution effect?

Flatter indifference
curve means larger
substitution effect.

14

The substitution effect represents a movement

along an indifference curve.

= (1 1 ) + (1 1 )
*

Econ 11-Lecture 6

How large is the substitution effect?

Change in Total Demand

1 = 1 10

Spring 2001

Steeper
indifference curve
means smaller
substitution effect.

Intuition: The income effect will be larger,

the more x1 originally purchased.
How to see this: Think about how much
extra income is needed to get back the
original bundle of goods when one price
increases.

new price = p1*

old price = p10
Spring 2001

Econ 11--Lecture 6

Econ 11-Lecture 6

17

Spring 2001

Econ 11-Lecture 6

18

Professor Jay Bhattacharya

Spring 2001

Compensated and Uncompensated

Changes in Demand

How Large is the Income Effect?

p1 x10 + p20 x20 = I1

p1* x10 + p20 x20 = I 2
0

p1 x10

Original

Uncompensated Change is the total change

resulting from a price change.
Marshallian Demand
What we observe
We separate the uncompensated change into 2
effects
substitution effect
income effect
Compensated demand is the change holding
utility constant, i.e., the substitution effect.

New

Income Needed

This quantity is larger if x10 is larger. Thus:

I = p1 x10
Spring 2001

Econ 11-Lecture 6

19

Spring 2001

Econ 11-Lecture 6

20

Derivation of Slutskys Equation

Slutskys Equation

x1 = x1S + x1I

An algebraic decomposition of the total

change in demand into income and
substitution effects
What do the relative size and sign of the
two effects imply for the change in
demand?

x1I =
=

x1I
I
I

x1
(p1 x10 )
I

x1 = x1
S

Spring 2001

Econ 11-Lecture 6

21

Spring 2001

Slutskys Equation
(in terms of rates of change)
x1 = x1
S

Econ 11--Lecture 6

Econ 11-Lecture 6

22

The rate of change in demand as price

changes (holding income fixed) is equal to
the rate of change in demand as prices change,
adjusting income; and
the rate of change in demand as income
changes holding prices fixed

x1 x
x 0
=

x1
p1 p1 I

Spring 2001

Econ 11-Lecture 6

Interpretation

x1I
0
p1 x1
I

x1I
0
p1 x1
I

I
1

23

Spring 2001

Econ 11-Lecture 6

24

Professor Jay Bhattacharya

Spring 2001

Law of Demand and Giffen Goods

Example of a Giffen Good

x2

The change in demand can be positive or negative since

the income effect can be positive or negative.

Case I: Law of Demand

Occurs if:

p1

dx1
<0
dp1

Demand
curve for a
Giffen
Good

x1 is normal, or
x1 is inferior and substitution effect > income effect

Case II: Giffen Good

Occurs if:
x1 is inferior, and
income effect > substitution effect

dx1
>0
dp
x1

Spring 2001

Econ 11-Lecture 6

25

Spring 2001

(Own) Price Elasticity of Demand

= x1

Fact: the price elasticity of demand tells us

how the total expenditure on a good
changes with price
Let T = total expenditure on x1 = x 1 p 1
How total expenditure changes with price =
dT
d p1
Econ 11-Lecture 6

27

Spring 2001

If

Good is relatively inelastic

Econ 11--Lecture 6

28

T = p1x1
Good 1 is relatively elastic

Spring 2001

Econ 11-Lecture 6

p1

If < 1 < 1

1 > 0

p1 dx1
+ x1
x1 dp1

Total Expenditure

dT
= x1 [1 + 1]
dp1

If

26

p dx

= x1 1 1 + 1
x1 dp1
= x1 [1 + 1]

Price Elasticity of Demand

dT
<0
dp1
dT
1 < 1 < 0
>0
dp1

Econ 11-Lecture 6

dT
dX
= p1 1 + x1
dp1
dp1

dx p
1 = 1 1
dp1 x1

Spring 2001

x1

Good 1 is a Giffen Good

x1
Econ 11-Lecture 6

29

Spring 2001

Econ 11-Lecture 6

30

Professor Jay Bhattacharya

Spring 2001

Relative Elasticity
p1

p1

x1
Relatively Elastic
Spring 2001

Econ 11--Lecture 6

Relatively Inelastic
Econ 11-Lecture 6

31