CDAE 254 - Class 10 Sept. 28

Last class:3. Individual demand curves

Today:3. Individual demand curvesQuiz 3 (Sections 3.1 – 3.4)

Next class:3. Individual demand curves

Important date:Problem set 3 due Tuesday, Oct. 10

3. Individual demand curves3.1. Basic concepts

3.2. Demand functions

3.3. Changes in income

3.4. Changes in a good’s price

3.5. Changes in the price of another good

3.6. Construction of individual demand curves

3.7. Consumer surplus

3.8. Applications

3.3. Changes in a good’s price (Px) 3.3.2. Income, substitution & total effects:

(1) Effects of a change in one price:

For example: An increase in Px sub. effect (X will decrease)

income effect (X will increase or or decrease, depending if X is normal or inferior)

(2) Income effect: change in quantity demanded that is caused by the change in real income (a movement from one indifference curve to another indifference curve).

(3) Substitution effect: change in quantity demanded that is caused by substitution of one good for another (a movement along an indifference curve).

(4) Total effect = income effect + sub. effect

3.3. Changes in a good’s price (Px)

3.3.3. Effects of an increase in one price

(1) Total effect

(2) Substitution effect & income effect

(3) Total effect =

3.3.4. Effect of a decrease in one price

(1) Total effect

(2) Substitution effect & income effect

(3) Total effect =

Substitution and income effects of normal goods due to a decrease in Px

3.3. Changes in a good’s price 3.3.5. Substitution & income effects for an inferior

good

(1) What is an inferior good?

(2) A graphic analysis (Fig. 3.5)

3.3. Changes in a good’s price 3.3.6. The lump-sum principle

(1) What is the lump-sum principal?

To collect the same amount of tax revenue, taxing income has smaller welfare (utility) impacts than

taxing one commodity or a narrow selection of commodities. Similarly, to increase the welfare (utility) to a particular level, subsiding income

will cost less than subsiding the price of one commodity or a narrow selection of commodities.

3.3. Changes in a good’s price 3.3.6. The lump-sum principle

(2) A graphic analysis

(a) Effects of a tax on X:

-- Budget constraint

-- Utility

-- Tax revenue T = t X1

(b) Effect of a tax on income

-- Budget constraint

-- Utility

-- Tax revenue = t X1

3.3. Changes in a good’s price 3.3.6. The lump-sum principle

(3) Explanation of the lump-sum principle

(a) A tax on X affects welfare in two ways:

-- It reduces purchase power (income effect)

-- It directs consumption away from the the taxed commodity (substitution effect)

(b) A tax on income affects welfare in only one way (income effect)

(4) The lump-sum principle and policy