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Price Effect and Derivation of the Consumer’s Demand Curve

Chapter Outline		XXX.1 PRICE EFFECT XXX.1.2 NUMERICAL EXAMPLE ON PRICE EFFECT XXX.2 TYPES OF PRICE EFFECT XXX.3 DERIVATION OF DEMAND CURVE XXX.4 CASE STUDY XXX.5 SUMMARY XXX.6 KEY TERMS XXX,7 EXERCISES XXX.8 QUESTIONS FOR DISCUSSION XXX.9 SUPPLIMENTARY READING XXX.10 INTERNET SITS XXX.11 PRICE EFFECT MATHEMATICALLY (APPENDIX)
XXX.1		PRICE EFFECT
Optimal Consumption PX MRSXY = - PY		In the previous section we have seen how optimal consumption combination, the one that maximizes the utility of spendable income, is determined at the point where budget constraint is tangent to an indifference curve. In other words, marginal rate of substitution equals the price ratio. As illustrated in Figure XXX.
		In this section we are going to change the price of good X (PX) and observe how consumption changes. Figure XXX.1 starts with the optimal consumption attained at point e1 as in Figure XXX.
Figure XXX.1 Optimal Consumption With Changing Prices		Units of Good Y P e2 e U2 e1 U U1 0 X1 X L1 X2 L L2 Units of Good X

		When the price of good X increases, the budget constraint then becomes steeper, as the lower end point moves leftward. This is depicted by budget constraint PL1. The optimal consumption is located at point e1 at which the consumer buys OX1 units of good X. Consumer’s total utility decreases as the equilibrium point is located on a lower indifference curve. Similarly, when the price of good X decreases, the budget constraint becomes flatter, as the lower end point moves rightward. This is depicted by budget constraint PL2. The optimal consumption is now located at point e2, at which the consumer buys OX2 units of good X. Consumer’s total utility increases as the equilibrium point is now located on a higher indifference curve. Whenever price of a good representing on X axis change, lower point of the budget constraint shifts, As such, consumer’s optimal consumption combination also changes. The consumer is better-off when optimal consumption combination is located on a higher indifference curve and vice versa. Thus, the price effect represents change in consumer’s optimal consumption combination on account of change in the price of a good and thereby changes in its quantity purchased, price of another good and consumer’s income remaining unchanged. [[Image:]]
XXX.1.2 NEUMERICAL EXAMPLE		PX = Rs.10 PY = Rs 5 - PX/PY = - 10/5 = - 2/1 Combination Units of Onion X Units of Tomato Y MRSxy a 12 25 - b 13 18 -7/1 c 14 13 - 5/1 d 15 10 -3/1 e 16 8 -2/1 f 17 7 -1/1 Equilibrium combination is 16X + 8Y Consumer spending (16*10 + 5*8 = 160 + 40 =200) Price of X has increased to Rs.20, Price of Y Rs.5 Income Rs.200 - PX/PY = - 20/5 = - 4/1 For Same combination (16*20 + 5*8 = 320+40 = 360) Combination Units of Onion X Units of Tomato Y MRSxy a 5 22 - b 6 16 -6/1 c 7 12 - 4/1 d 8 9 -3/1 e 9 7 -2/1 f 10 6 -1/1 Equilibrium combination is 7X + 12Y 7*20 + 12*5 = 140 + 60 = 200
XXX.2 TABLE XXX.1 Impact of fall in price of X on its purchase.		TYPES OF PRICE EFFECTS In Figure XXX.1, with increase in price of good X the consumer reduces its consumption and vice versa. This pattern of consumer’s choice is observed when good X is a normal good. The following table presents types of price effect in case of different nature of goods. Type of Price Effect Nature of Good X Quantity Demanded of Good X Positive Normal Negative Inferior (including Giffen Goods) Zero Neutral No Change in Quantity Demanded
XXX.3		DERIVATION OF THE CONSUMER’S DEMAND CURVE Figure XXX.1, depicting price effect establishes consumer’s demand behavior. When the price of good X increases, as depicted by the budget constraint PL1, the consumer reduces consumption of good X (OX1). Similarly, when the price of good X decreases, as depicted by the budget constraint PL2, the consumer increases consumption of good X (OX2). In other words, Figure XXX.1 confirms the law of demand. This is shown in Figure XXX.2. Points a, b and c correspond to quantity demanded of good X corresponding to its price at optimal consumption combinations e1, e and e2 respectively.
Figure XXX.2		Price of Good X P D a b c D 0 X1 X X2 Units of Good X
XXX.4		CASE STUDY Global Hunger Index 2011 - The Challenge of Hunger: Taming Price Spikes and Excessive Food Price Volatility Report — Concern Worldwide, Deutsche Welthungerhilfe e. V. (German Agro Action), International Food Policy Research Institute 2011 Global Hunger Index Fact and Findings: Asia South Asia has the highest regional 2011 Global Hunger Index (GHI) score—22.6. The 2011 GHI score fell by 25 percent in South Asia compared with its 1990 score, and the 2011 GHI score in Southeast Asia decreased by 44 percent. The South Asia region reduced its GHI score by more than 6 points between 1990 and 1996—mainly due to a large decline in underweight in children under five, but the fast progress was not maintained. South Asia has lowered its GHI score by only one point since 2001 despite strong economic growth. Social inequality and the low nutritional, educational, and social status of women, which is a major cause of child under nutrition in the region, have impeded improvements in the GHI score. Bangladesh and Vietnam saw large gains in improving their GHI score between the 1990 GHI and the 2011 GHI. Vietnam reduced its score by 56 percent, and Bangladesh reduced its score by 36 percent. In Bangladesh—a country where 25 percent of the population is ultra-poor (living on less than USD $0.50 a day)—only about 7 percent of the population has access to social protection or safety net programs. The GHI score for North Korea increased by 18 percent since 1990. A weak economy, high military spending, weather-related crop failures, and systematic problems in the agricultural sector have hampered progress. Cambodia is the only country to improve from an “extremely larming” to “serious” level of hunger since 1990. Bangladesh, India, and Timor-Leste have the highest prevalence—more than 40 percent—of underweight in children under five. India ranks below China, Pakistan in Global Hunger Index 2011 ET Bureau Oct 12, 2011, 04.13am IST Tags: Pakistan| Klaus von Grebmer| India NEW DELHI: India ranked way below its South Asian neighbours Pakistan, Sri Lanka and China in the global hunger index 2011 released by the International Food Policy and Research Institute. South Asia fared worse than Sub-Saharan Africa netting a score of 22.6 on the global hunger index, or GHI, the report said. While, India stood 67th amongst 81 countries, Pakistan ranked 59, China ranked fourth, Vietnam ranked 25 and Sri Lanka ranked 36 in the GHI. The report blamed high volatility in food prices for rising hunger levels worldwide. "The poorest and most vulnerable people bear the heaviest burden when food prices spike or swing unpredictably," said Klaus von Grebmer, lead author of the report and IFPRI Communications Director in the press release.
XXX.5		SUMMARY People respond to changes in relative prices in order to maximize the utility of spendable income. The price effect represents changes in optimal consumption combination on account of changes in relative prices. In term of indifference curves, a consumer is better-off when optimal consumption combination is located on a higher indifference curve and vice versa, as a result of relative price changes. Consumer’s responses to relative price changes vary depending upon the nature of goods. It is positive, negative and zero for normal good, inferior good and neutral good respectively. These varying responses are important determinants of different forms of market demand curves.
XXX.6		KEY TERMS Marginal Rate of Substitution: It is the rate at which the consumer is willing to substitute one good for another in consumption. Price Effect: It represents change in consumer’s optimal consumption combination on account of change in the price of a good and thereby changes in its quantity purchased, price of another good and consumer’s income remaining unchanged. Positive Price Effect is obtained in case of normal goods. In this case changes in quantity demanded of a good, as a result of price effect, are inversely related to the price change. Negative Price Effect is obtained in case of inferior goods (including Giffen goods). In this case changes in quantity demanded of a good, as a result of price effect, are directly related to the price change. Zero Price Effect is obtained in case of neutral goods. In this case there are no changes in quantity demanded of a good as a result of price effect.
XXX.7 Exercise XXX 1.1		EXERCISES Complete the following diagram to depict negative price effect
		Units of Good Y P e U1 0 X L Units of Good X (Inferior Good)
Exercise XXX 1.2		Complete the following diagram to depict zero price effect
		Units of Good Y P e U1 0 X L Units of Good X (Neutral Good)
		[[Image:]]
Exercise XXX 1.3 Figure XXX.3.		Part (a) of the graph depicts consumer’s quantity demanded at optimal consumption combinations as stated in the neumerical example. Derive the demand curve in the lower part (b) of the graph. Units of Good Y Units of Good X Price of Good X (b) Units of Good X
XXX.8		QUESTIONS FOR DISCUSSION
XXX.9		SUPPLEMENTARY READING
XXX.10		INTERNET SITS
XXX.11		PRICE EFFECT MATHEMATICALLY

Microeconomics, Macroeconomics and Economic Policy

Essays in Honour of Malcolm Sawyer Edited by Philip Arestis Palgrave Macmillan, September 2011ISBN: 978-0-230-29019-8, ISBN10: 0-230-29019-1, 6 1/8 x 9 1/4 inches, 280 pages, 8 b/w tables, 15 figures,

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= ‘Rise in income helps cope with price rise’ = TNN Jun 29, 2011, 05.25am IST NEW DELHI: A study by rating agency Crisil on the toll that inflation has taken between 2008-09 and 2010-11 has pointed out that among the 316 goods that have registered a sharp rise in prices, 36 are raw food products, while another 14 are fuel items. For instance, milk prices have trebled during the last two years, most fruits and vegetables have witnessed double-digit price increase, while prices of egg, meat and fish rose 23.6% in 2010-11."As disposable incomes rise, consumer preferences have been shifting towards protein-based food items such as egg, meat, fish and milk from traditional food grains and cereals, thereby pushing up prices of the former category," Crisil economists Parul Bhardwaj, Vidya Mahambare and D K Joshi said in the report.Though supply side factors have been blamed for higher inflation, within the UPA too there have been murmurs of mismanagement on the price front, [[Image:]]

PRICE EFFECT

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