Difficulty: Intermediate | Prerequisites: Consumer Choice and Preferences notes (budget constraints, indifference curves, MRS, optimal bundle).
This topic bridges the gap between consumer choice theory and market-level analysis. Once you understand how an individual picks an optimal bundle, the next question is: what happens to that choice when prices or income change? The answer gives you the individual demand curve. Aggregating those curves across consumers gives you the market demand curve, and measuring how responsive demand is to price or income changes gives you elasticity.
If consumer choice was the engine, this topic is the steering. You need it for analysing welfare (consumer surplus), understanding tax incidence, and predicting how markets respond to shocks. Everything here feeds directly into the producer and market structure topics that follow.
A price change affects demand through two channels: the substitution effect (the good is now relatively cheaper or dearer) and the income effect (purchasing power has changed). Price elasticity measures how strongly quantity demanded responds to price changes. Whether demand is elastic or inelastic determines what happens to total expenditure when price moves, which matters for firms setting prices and governments setting taxes.
Demand curve
A graph showing the quantity of a good consumers will buy at each price, holding other factors constant. Its purpose is to measure how consumers respond to changes in the price of a good.
Substitution effect
The change in quantity demanded resulting from a change in relative price, with utility held constant. It always works against the price change: if the price rises, the substitution effect reduces quantity demanded. Think of it as: the good just got relatively more expensive, so you switch toward alternatives.
Income effect
The change in quantity demanded resulting from the change in purchasing power caused by a price change, with relative prices held constant. Its direction depends on whether the good is normal or inferior.
Normal good
A good the consumer buys more of as income rises. Examples: steak, a nice car, a new computer. For normal goods, the income effect reinforces the substitution effect.
Inferior good
A good the consumer buys less of as income rises, because they can now afford something better. Example: public transit when a car becomes affordable. For inferior goods, the income effect works against the substitution effect.
Luxury good
A good with income elasticity greater than 1 (Em > 1). Demand grows faster than income.
Necessity good
A good with income elasticity between 0 and 1 (0 < Em < 1). Demand grows, but more slowly than income.
Price elasticity of demand
The responsiveness of consumers to changes in market price. Calculated as the percentage change in quantity demanded divided by the percentage change in price. In simple terms, it tells you how much sales drop when you raise the price by 1%.
Elastic demand (|E| > 1)
Consumers are responsive to price changes. A price reduction increases total expenditure.
Inelastic demand (|E| < 1)
Consumers are relatively unresponsive to price changes. A price reduction decreases total expenditure.
Unit elastic demand (|E| = 1)
Percentage change in quantity exactly matches percentage change in price. Total expenditure is at its maximum.
Income elasticity of demand (Em)
The percentage change in quantity demanded resulting from a percentage change in income. Positive for normal goods, negative for inferior goods.
Cross-price elasticity (Ex,y)
The percentage change in quantity demanded of good X resulting from a percentage change in the price of good Y. Positive means substitutes; negative means complements.
Consumer surplus
The difference between what a consumer is willing to pay for a good and what they pay. Think of it as: the bonus you get from buying something for less than your maximum price.
Price-consumption curve (PCC)
The set of optimal bundles traced out as the price of one good changes, holding income and the other price constant. It slopes upward because utility is higher when more can be consumed.
Engel curve
A curve showing how consumption of a good changes as income changes, holding prices constant. Slopes upward for normal goods, bends backward for inferior goods.
Aggregate (market) demand curve
The horizontal sum of all individual demand curves. Found by adding quantities (not prices) at each price level.
Positive network externality (bandwagon effect)
Consumers buy more of a good because other people are buying it. Examples: social media platforms, Microsoft Office.
Negative network externality (snob effect)
Consumers buy less of a good because other people are buying it. Examples: limited-edition items, ski tickets at a crowded resort.
From budget constraint to demand curve
At each price of good X, the budget line pivots, producing a new optimal bundle (tangency with the highest IC).
Plotting each price against the corresponding optimal quantity of X traces out the individual demand curve.
As price falls, the consumer moves to higher indifference curves (greater utility).
Price-consumption curve (PCC)
The PCC connects all optimal bundles as the price of one good varies.
It slopes upward because utility is higher when more can be consumed (monotonicity).
Each point on the PCC satisfies two conditions: utility is maximised and all income is spent.
Shifts in the demand curve
A change in price causes a movement along the demand curve.
Factors that shift the entire demand curve: income, prices of related goods, tastes, expectations, number of buyers.
Shifts in the supply curve
Input prices, technology, number of sellers, expectations.
Decomposing a price change
When the price of good X changes, two things happen simultaneously:
Substitution effect: the movement from the original bundle to a hypothetical bundle on the original IC at the new price ratio. It always works against the price change (price up, quantity down; price down, quantity up). It always reduces the quantity demanded of the good whose price increased.
Income effect: the movement from the hypothetical bundle to the actual new optimal bundle. The direction depends on whether the good is normal or inferior.
Normal goods: both effects reinforce each other
If the price of a normal good rises, the substitution effect says buy less (it is relatively dearer) and the income effect also says buy less (real income has fallen, and you buy less of normal goods when poorer).
For a normal good with a price increase: substitution effect = less; income effect = less.
Inferior goods: effects work against each other
If the price of an inferior good rises, the substitution effect says buy less, but the income effect says buy more (real income has fallen, and you buy more of inferior goods when poorer).
The substitution effect typically dominates, so demand still falls when price rises, but by less than for a normal good.
For inferior goods, the income effect works against the substitution effect.
An increase in real income causes:
Increased demand for normal goods.
Decreased demand for inferior goods.
Perfect substitutes
The substitution effect is the only thing operating. The consumer switches entirely to whichever good is cheaper.
Perfect complements
There is no substitution effect (the fixed ratio cannot change). Only the income effect matters.
How to find market demand
Rewrite each individual's demand function in terms of Q (quantity as a function of price).
Add individual quantities: Qmarket = Q1 + Q2 + ... + Qn.
Rewrite in terms of P if needed for graphing.
Price elasticity of demand formulas
E = (% change in Qd) / (% change in P)
E = (Change in Q / Q0) / (Change in P / P0)
E = (dQ/dP) * (P/Q)
Most commonly used: E = (P/Q) * (1/slope of the demand curve)
Elasticity categories
|E| > 1: elastic. Consumers are responsive. A price cut raises total expenditure.
|E| = 1: unit elastic. Total expenditure is at its maximum.
|E| < 1: inelastic. Consumers are less responsive. A price cut reduces total expenditure.
E = 0: perfectly inelastic. Quantity does not change at all (vertical demand curve). Example: essential goods with no substitutes.
E = infinity: perfectly elastic. Any price increase causes demand to drop to zero (horizontal demand curve).
Determinants of elasticity
Substitute possibilities: fewer close substitutes means less elasticity and a smaller substitution effect. Sirloin steak is more elastic than "all meat" because there are more substitutes for sirloin specifically.
Share of budget: large-ticket items are more elastic (larger income effect).
Direction of income effect: normal goods are more elastic than inferior goods because the income effect reinforces the substitution effect.
Time: over time, consumers adjust better, so long-run demand is more elastic than short-run demand.
Income elasticity (Em)
Em = (Change in Q / Change in M) * (M / Q)
Em > 1: luxury good.
0 < Em < 1: necessity good.
Em < 0: inferior good.
If the Engel curve slopes upward, the good is normal (Em > 0). If it bends backward, the good is inferior (Em < 0).
Cross-price elasticity (Ex,y)
Ex,y = (% change in Qx) / (% change in Py)
Ex,y > 0: goods are substitutes.
Ex,y < 0: goods are complements.
Example: if the price of iPhones generates a cross-price elasticity for Apple Watches of -0.6, they are complements.
Elasticity and total expenditure
In the elastic region, a 1% price decrease generates more than a 1% quantity increase, so total expenditure rises.
At unit elasticity, expenditure is maximised (optimal for a revenue-maximising firm).
In the inelastic region, a 1% price decrease generates less than a 1% quantity increase, so total expenditure falls.
Tax pass-through (buyer's burden)
Pass-through = Es / (Es - Ed), where Es is supply elasticity and Ed is demand elasticity.
Whichever side (consumer or producer) is more inelastic bears more of the tax burden.
Aggregating individual demand
Market demand is the horizontal sum of individual demand curves: at each price, add up all individual quantities.
Steps: (1) rewrite each individual demand as Q = f(P), (2) sum all Q values, (3) rewrite as P = g(Q) if needed.
Example: if men's quarterly demand is Qd = 3 - 0.25P and women's is Qd = 4 - 0.5P, with 10,000 of each, market demand at P = $6 is 10,000(1.5) + 10,000(1) = 25,000 bottles.
Consumer surplus
Consumer surplus is the difference between a consumer's maximum willingness to pay and the market price.
Graphically, it is the area between the demand curve and the price line.
When the price of an input (e.g. wood for furniture) falls, the supply of the final good shifts right, price falls, and consumer surplus for the final good increases.
Network externalities
Positive (bandwagon effect): demand increases because others are buying. As more features are embedded in software, the individual demand curve becomes more elastic due to the bandwagon effect.
Negative (snob effect): demand decreases because others are buying. Limited editions and rare items.
Price elasticity: E = (%ΔQ) / (%ΔP) = (dQ/dP) * (P/Q) = (P/Q) * (1/slope)
Income elasticity: Em = (ΔQ/ΔM) * (M/Q)
Cross-price elasticity: Ex,y = (%ΔQx) / (%ΔPy)
Tax pass-through: Es / (Es - Ed)
Tax incidence on sellers: (P - P2) * Q2
Tax incidence on buyers: (P2 + tax - P) * Q2
Key diagrams to know
Decomposition of a price change into substitution and income effects using the compensated (hypothetical) budget line.
Individual demand curve derived from shifting budget lines.
Elastic vs. inelastic demand curves (flatter = more elastic).
Horizontal summation of individual demand curves to get market demand.
Consumer surplus as the area between the demand curve and the price line.
Supply and demand shifts caused by excise taxes on buyers vs. sellers.
Students often think the substitution effect can work in the same direction as a price increase (i.e. buying more when price rises). It cannot. The substitution effect always works against the price change.
Students confuse elastic and inelastic with steep and flat. A flatter demand curve is more elastic at any given point, but elasticity also depends on where you are on the curve (it changes along a linear demand curve).
Students assume that if a good is inferior, demand rises when price rises. This is extremely rare (Giffen goods). For most inferior goods, the substitution effect still dominates and demand falls.
Students mix up movements along the demand curve (caused by a price change) with shifts of the demand curve (caused by income, tastes, or other factors).
Expect questions asking you to decompose a price change into substitution and income effects, often with a diagram.
Know the direction of each effect for normal goods, inferior goods, perfect substitutes, and perfect complements.
Elasticity calculations are heavily tested. Practise computing elasticity from demand functions and from data points.
Understand the relationship between elasticity and total expenditure (revenue) at each elasticity range.
Be ready for questions about gasoline: short-run elasticity is low (inelastic, ~0.3), long-run is higher (elastic, ~1.4), so a tax increase raises consumer expenditure in the short run but reduces it in the long run.
Know how to aggregate individual demands into market demand (add Q, not P).
True or false: the substitution effect always reduces the quantity demanded of the good whose price increased. True.
Fill in the blank: for a normal good, the income effect of a price decrease causes the consumer to buy ____ of the good. More.
True or false: if demand is inelastic, a price reduction increases total expenditure. False (it decreases total expenditure).
Fill in the blank: cross-price elasticity is positive for ____ and negative for ____. Substitutes; complements.
True or false: at each point along a price-consumption curve, utility is maximised and all income is spent. True.
Q: Assume yogurt is a normal good. If the price of yogurt rises, what happens to consumption via the substitution effect and the income effect?
A: The substitution effect results in the person buying less yogurt, and the income effect also results in buying less yogurt. Both effects reinforce each other for a normal good.
Q: The demand for artichokes is Qa = 200 - 4P. If price is increased slightly from $10, what happens to total expenditure and quantity sold?
A: Total expenditure rises and quantity sold falls. At P = $10, Q = 160 and E = (P/Q)(1/slope) = (10/160)(1/(1/4)) = 0.25 (inelastic). With inelastic demand, a price increase raises total expenditure.
Q: Short-run price elasticity of gasoline is -0.3 and long-run is -1.4. What happens to consumer expenditure if the government raises the gasoline tax?
A: Consumer expenditures on gasoline increase over the short run (demand is inelastic, so the price increase raises total spending) and decline over the long run (demand becomes elastic, so consumers adjust and total spending falls).
Q: What is the value of the Lerner index under perfect competition?
A: 0. Under perfect competition, price equals marginal cost, so (P - MC)/P = 0.
Q: When the income-consumption curve has a positive slope throughout its entire length, what can we conclude?
A: Both goods are normal. A positive slope means consumption of both goods increases as income rises.
Elasticity feeds directly into the analysis of market structure: a firm's pricing power depends on how elastic demand is. The substitution and income effects reappear in production theory as firms substitute between labour and capital in response to input price changes. Consumer surplus is the welfare measure used throughout the course to evaluate policy interventions such as taxes, price controls, and subsidies.
Demand curve, substitution effect, income effect, normal good, inferior good, Giffen good, luxury good, necessity good, price elasticity, income elasticity, cross-price elasticity, elastic, inelastic, unit elastic, perfectly elastic, perfectly inelastic, total expenditure, total revenue, consumer surplus, willingness to pay, price-consumption curve, PCC, Engel curve, aggregate demand, market demand, horizontal summation, network externalities, bandwagon effect, snob effect, tax incidence, pass-through, excise tax, ad valorem tax, ECO 3101, intermediate microeconomics, FIU