Lecture 7
THE DEMAND CURVE

• Substitution and income effects
• Normal and inferior goods
• Giffen goods
• Consumer surplus

1. Effect of income change on consumption

Consider an increase in income.
• What happens to the budget constraint?
• What happens to the optimal bundle?

Normal good: Higher income leads to greater consumption of the good

Inferior good: Higher income leads to lower consumption of the good
• Examples?

2. Effect of price change on consumption

Consider a decrease in the price of a good. How does the optimal bundle change?
• Use tangency condition
Derivation of demand curve
• As price of a good decreases, ceteris paribus, the quantity demanded increases
  
• Negative slope
Substitution effect: A decrease in price induces substitution towards cheaper good (and away from relatively more expensive good)
Income effect: A decrease in price allows consumers to buy more of both goods
Giffen goods: Higher the price, greater is the quantity demanded
• Upward-sloping demand curve!
• Examples?

3. Consumer Surplus

• The difference between what the consumer is willing to pay and what he actually pays for the good.
  
  
• Area of the triangle below the demand curve and above the market price.
  
  
• Measured in dollars
  
  
• As price rises, CS decreases. Why?