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MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.
Market Demand Curves
• Assume that there are only two goods
(X and Y) and two individuals (1 and 2)
– The first person’s demand for X is
X1 = dX1(PX,PY,I1)
– The second person’s demand for X is
X2 = dX2(PX,PY,I2)
Market Demand Curves
• Features of these demand curves:
– Both individuals are assumed to face the
same prices
– Each buyer is assumed to be a price taker
• must accept the prices prevailing in the market
– Each person’s demand depends on his or
her own income
Market Demand Curves
• The total demand for X is the sum of the
amounts demanded by the two buyers
– The demand function will depend on PX,
PY, I1, and I2
total X = X1 + X2
total X = dX1(PX,PY,I1) + dX2(PX,PY,I2)
total X = DX(PX,PY,I1,I2)
Market Demand Curves
• To construct the market demand curve,
PX is allowed to vary while PY, I1, and I2
are held constant
• If each individual’s demand for X is
downward sloping, the market demand
curve will also be downward sloping
Market Demand Curves
To derive the market demand curve, we sum the
quantities demanded at every price
PX PX PX
Individual 1’s Individual 2’s Market demand
demand curve demand curve curve
PX*
dX1 DX
dX2
X1* X X2* X X* X
X1* + X2* = X*
Shifts in the Market
Demand Curve
• The market demand summarizes the
ceteris paribus relationship between X
and PX
– Changes in PX result in movements along the
curve (change in quantity demanded)
– Changes in other determinants of the
demand for X cause the demand curve to
shift to a new position (change in demand)
Shifts in Market Demand
• Suppose that individual 1’s demand for
oranges is given by
X1 = 10 – 2PX + 0.1I1 + 0.5PY
and individual 2’s demand is
X2 = 17 – PX + 0.05I2 + 0.5PY
• The market demand curve is
X = X1 + X2 = 27 – 3PX + 0.1I1 + 0.05I2 + PY
Shifts in Market Demand
• To graph the demand curve, we must
assume values for PY, I1, and I2
X PX X PX PX X X I
PX X PX X U constant
I I X
Slutsky Equation in Elasticities
• A substitution elasticity shows how the
compensated demand for X responds to
proportional compensated price changes
– it is the price elasticity of demand for
movement along the compensated demand
curve
X PX
e S
PX X
X ,PX
U constant
Slutsky Equation in Elasticities
• Thus, the Slutsky relationship can be
shown in elasticity form
eX ,PX eX ,PX s X eX ,I
S
eY ,PY 1 eY ,I 1 eY ,PY 1
• Note that
PX X PYY
sX sY
I I
Cobb-Douglas Elasticities
• Homogeneity can be shown for these
elasticities
e X ,PX e X ,PY e X ,I 1 0 1 0
• The elasticity version of the Slutsky
equation can also be used
eX ,PX eX ,PX s X eX ,I
S
1 e S
X ,PX (1)
e S
X ,PX (1- )
Cobb-Douglas Elasticities
• The price elasticity of demand for this
compensated demand function is equal
to (minus) the expenditure share of the
other good
• More generally
eSX ,PX (1 - s X )
where is the elasticity of substitution
Linear Demand
Q = a + bP + cI + dP’
where:
Q = quantity demanded
P = price of the good
I = income
P’ = price of other goods
a, b, c, d = various demand parameters
Linear Demand
Q = a + bP + cI + dP’
• Assume that:
– Q/P = b 0 (no Giffen’s paradox)
– Q/I = c 0 (the good is a normal good)
– Q/P’ = d ⋛ 0 (depending on whether the
other good is a gross substitute or gross
complement)
Linear Demand
• If I and P’ are held constant at I* and
P’*, the demand function can be written
Q = a’ + bP
where a’ = a + cI* + dP’*
– Note that this implies a linear demand
curve
– Changes in I or P’ will alter a’ and shift the
demand curve
Linear Demand
• Along a linear demand curve, the slope
(Q/P) is constant
– the price elasticity of demand will not be
constant along the demand curve
Q P P
eQ,P b
P Q Q
• As price rises and quantity falls, the
elasticity will become a larger negative
number (b < 0)
Linear Demand
P Demand becomes more
elastic at higher prices
-a’/b eQ,P < -1
eQ,P = -1
eQ,P > -1
Q
a’
Constant Elasticity Functions
• If one wanted elasticities that were
constant over a range of prices, this
demand function can be used
Q = aPbIcP’d
where a > 0, b 0, c 0, and d ⋛ 0.
• For particular values of I and P’,
Q = a’Pb
where a’ = aIcP’d
Constant Elasticity Functions
• This equation can also be written as
ln Q = ln a’ + b ln P
• Applying the definition of elasticity,
Q P ba' P b 1 P
eQ,P b
P Q a' P b