Difficulty: Intermediate | Prerequisites: Consumer Theory notes (indifference curves, budget constraints, MRS)
Demand theory traces how individual consumers' optimal choices respond to price and income changes, then aggregates those responses into market demand. Elasticity measures how sensitive quantity demanded (or supplied) is to a change in price, income or the price of another good. The substitution effect and income effect together explain why demand curves usually slope downward.
Substitution effect
The change in consumption of a good associated with a change in its price, holding the level of utility constant. Consumers buy more of the good that has become cheaper and less of the one that is now relatively more expensive.
Income effect
The change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant. When one good becomes cheaper, the consumer's real purchasing power rises.
In simple terms: a price drop makes you "richer" in real terms, and you spend some of that gain.
Total effect
Substitution effect + income effect.
Price-consumption curve
A curve tracing the utility-maximising combinations of two goods as the price of one changes. At every point, utility is maximised and all income is spent.
Income-consumption curve
A curve tracing the utility-maximising combinations of two goods as a consumer's income changes.
Engel curve
A curve relating the quantity of a good consumed to income. For a normal good, this slopes upward; a backward-bending Engel curve indicates a switch from normal to inferior.
Normal good
A good for which consumption rises when income rises.
Inferior good
A good for which consumption falls when income rises.
Giffen good
A good whose demand curve slopes upward because the negative income effect is larger than the substitution effect. Rare in practice (classic example: bread as a staple).
Market demand curve
A curve relating the quantity of a good that all consumers in a market will buy to its price. Found by horizontally summing individual demand curves.
In simple terms: at each price, add up how much everyone wants to buy.
Elasticity
The percentage change in one variable resulting from a 1% increase in another.
Elastic demand
|E| > 1. Total expenditure on the product decreases as price increases.
Inelastic demand
|E| < 1. Total expenditure on the product increases as price increases.
Unit elastic demand
|E| = 1. Total expenditure is unchanged when price changes.
Isoelastic demand curve
A demand curve with constant price elasticity. It is downward-sloping and convex.
Cross-price elasticity
Measures responsiveness of quantity demanded of one good to a change in the price of another. Positive = substitutes; negative = complements.
Income elasticity of demand
Measures responsiveness of quantity demanded to a change in income. Greater than 1 = elastic with respect to income (luxury); less than 1 but positive = necessity; negative = inferior good.
Network externality
When each individual's demand depends on the purchases of other individuals.
Bandwagon effect
A positive network externality: consumers want a good in part because others have it. Makes demand more elastic.
Snob effect
A negative network externality: consumers want to own an exclusive or unique good. Makes the demand curve steeper.
Speculative demand
Demand driven not by direct consumption benefits but by an expectation that the price will increase.
Durable good
A good used over time rather than consumed all at once. Income elasticity of demand is larger in the short run than in the long run.
Price elasticity of supply
The percentage change in quantity supplied in response to a 1% increase in price.
The individual demand curve is traced by varying the price of one good, finding the new optimal bundle on each budget line, and plotting price against quantity. Two properties hold at every point on this curve:
The level of utility that can be attained changes as we move along the curve.
At every point, the consumer is maximising utility by setting MRS equal to the price ratio.
When a good's price falls, two things happen simultaneously:
Substitution effect: the good is now cheaper relative to others, so the consumer buys more of it and less of the other (measured holding utility constant).
Income effect: the consumer's real purchasing power has risen, which changes consumption of both goods.
For a normal good, both effects push consumption in the same direction (price falls, buy more). For beer as a normal good: if the price rises, the substitution effect leads to buying less, and the income effect also leads to buying less.
For an inferior good, the income effect works against the substitution effect. A Giffen good is the extreme case where the income effect dominates, producing an upward-sloping demand curve.
The market demand curve sums individual quantities at each price. It shifts rightward as more consumers enter the market, and any factor that influences individual demands also shifts market demand.
Worked example: A retailer faces male demand Qd = 3 - 0.25P and female demand Qd = 4 - 0.5P, with 10,000 men and 10,000 women. At P = $6: men each buy 3 - 0.25(6) = 1.5, women each buy 4 - 0.5(6) = 1. Total = 10,000(1.5) + 10,000(1) = 25,000 bottles.
Price elasticity of demand = % change in Qd / % change in P.
Elastic (|E| > 1): a price rise lowers total revenue.
Inelastic (|E| < 1): a price rise increases total revenue.
Unit elastic (|E| = 1): total revenue unchanged.
Completely inelastic: vertical demand curve, Qd is fixed regardless of price.
Infinitely elastic: horizontal demand curve, any price above a threshold sends Qd to zero.
A linear demand curve Q = a - bP is plausible only if no important factors other than price affect demand.
Short-run vs long-run elasticity: Gasoline in the US has a short-run price elasticity of -0.3 (inelastic) and a long-run elasticity of -1.4 (elastic). A tax increase therefore raises consumer expenditures in the short run but reduces them in the long run.
For most goods and services, income elasticity of demand is larger in the long run. For durable goods, income elasticity is larger in the short run.
Positive cross-price elasticity: substitutes. iPhone price rises, Samsung Galaxy sales rise (cross-price elasticity = 0.7).
Negative cross-price elasticity: complements. iPhone price rises, Apple Watch sales fall (cross-price elasticity = -0.6).
If income elasticity of demand for cinema is 1.5, a 1% increase in income leads to a 1.5% increase in cinema attendance. Demand for cinema is elastic with respect to income.
If elasticity is negative (or inelastic), the share of income spent on that good decreases when income increases.
Software companies that add features for interaction and sharing create bandwagon effects, making individual demand more elastic. Peanut butter and jelly are complements: if peanut butter's price rises, the demand curve for jelly shifts left; if it falls, the demand curve for jelly shifts right.
Supply curves slope upward; demand curves slope downward.
When price is below the market-clearing level, quantity demanded exceeds quantity supplied (shortage).
A new, cheaper production technology shifts supply rightward (higher Q, lower P).
A new product with higher demand for raw materials shifts demand rightward (higher Q, higher P).
The supply curve for ethanol shifts rightward when biochemists discover an enzyme that doubles ethanol yield from biomass.
When battery costs for electric vehicles decline, the supply curve for those vehicles shifts rightward.
Price elasticity of demand: Ed = (% change in Qd) / (% change in P)
Income elasticity of demand: Ei = (% change in Qd) / (% change in income)
Cross-price elasticity: Exy = (% change in Qd of X) / (% change in price of Y)
Price elasticity of supply: Es = (% change in Qs) / (% change in P)
Market demand: sum individual Qd at each price across all consumers.
Total effect of a price change = substitution effect + income effect.
Elasticity tells firms what happens to revenue when they raise or lower prices. A petrol station facing inelastic short-run demand knows a price hike will raise revenue immediately, but over time consumers switch to public transport or fuel-efficient cars, making demand elastic and the strategy unsustainable. Cross-price elasticity helps firms predict how a competitor's price change will affect their own sales.
Students often confuse the substitution effect with the income effect. The substitution effect is measured holding utility constant (sliding along the same indifference curve). The income effect is measured holding relative prices constant (shifting to a new indifference curve).
A common error is thinking that inferior goods always have upward-sloping demand curves. They do not: only Giffen goods (a subset of inferior goods where the income effect outweighs the substitution effect) have upward-sloping demand.
Students assume that a higher price always means less total spending. That is true only for elastic demand. With inelastic demand, a price increase raises total expenditure.
Network externalities are not the same as externalities in welfare economics. A bandwagon effect increases your demand because others buy the good, not because of a cost or benefit imposed on third parties.
⚠️ Be able to decompose a price change into substitution and income effects, and state which direction each pushes for normal, inferior and Giffen goods.
⚠️ Market demand aggregation problems are common: sum individual Qd functions and plug in the given price.
⚠️ Know how to determine whether goods are substitutes or complements from the sign of the cross-price elasticity.
⚠️ Short-run vs long-run elasticity questions often appear with gasoline as the example. Memorise the direction: expenditure rises in the short run and falls in the long run after a tax increase.
⚠️ The demand curve for a Giffen good is upward-sloping in the relevant price range. This is a favourite true/false question.
True or false: The substitution effect is measured holding income constant. (False, it is measured holding utility constant.)
Fill in the blank: A positive cross-price elasticity means the goods are ______. (substitutes)
True or false: For a normal good, both the substitution and income effects of a price decrease lead to buying more. (True.)
Fill in the blank: If |E| < 1, demand is ______. (inelastic)
True or false: An increase in income shifts the budget line outward without changing its slope. (True.)
Q: A retailer sells shampoo. Male demand: Qd = 3 - 0.25P. Female demand: Qd = 4 - 0.5P. Market has 10,000 men and 10,000 women. How many bottles sell at P = $6?
A: Men: 3 - 0.25(6) = 1.5 each, so 15,000 total. Women: 4 - 0.5(6) = 1 each, so 10,000 total. Market quantity = 25,000.
Q: The short-run price elasticity of demand for gasoline is -0.3 and the long-run is -1.4. What happens to consumer expenditures if the government raises the gasoline tax?
A: Expenditures increase in the short run (demand is inelastic) and decline over the long run (demand is elastic).
Q: If the cross-price elasticity between iPhones and Samsung Galaxy phones is 0.7, what is their relationship?
A: They are substitutes (positive cross-price elasticity).
Q: If the cross-price elasticity between iPhones and Apple Watches is -0.6, what is their relationship?
A: They are complements (negative cross-price elasticity).
Q: Beer is a normal good. If its price rises, what do the substitution and income effects each do to the quantity purchased?
A: Both lead to buying less beer. Substitution effect: beer is relatively more expensive, so you buy less. Income effect: purchasing power falls, so you buy less of the normal good.
Q: Artichoke demand is Qa = 200 - 4P. At P = $10, the price rises slightly. What happens to total expenditure and quantity sold?
A: At P = 10, Qa = 160. Point elasticity = -4 * (10/160) = -0.25 (inelastic). Total expenditure rises, quantity sold falls.
Demand theory builds directly on consumer theory (indifference curves and budget constraints). The market demand curve is the foundation for analysing perfectly competitive markets, where the firm faces a horizontal demand curve at the market price. Elasticity reappears in welfare analysis: the more elastic the demand or supply, the smaller the deadweight loss from a tax or price control.
demand theory, elasticity, price elasticity of demand, income elasticity, cross-price elasticity, substitution effect, income effect, Giffen good, inferior good, normal good, Engel curve, market demand, network externality, bandwagon effect, snob effect, speculative demand, isoelastic demand, durable good, price elasticity of supply, intermediate microeconomics, FIU, demand curve shift, complements, substitutes