chapter 4 individual and market demand. topics to be discussed n individual demand n income and...

Chapter 4

Individual and

Market Demand

Topics to be Discussed

Individual Demand

Income and Substitution Effects

Market Demand

Consumer Surplus

Topics to be Discussed

Network Externalities

Empirical Estimation of Demand

Individual Demand

Price Changes

• Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.

Individual Demand

The Demand Curve

• The price-consumption curve traces the utility-maximizing combinations of food and clothing associated with each and every price of food.

• The demand curve relates the quantity of food that the consumer will buy to the price of food.

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

The budget linesillustrate three

prices for food--$2

$2

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

The budget linesillustrate three

prices for food--$2, $1,

$2 $1

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

The budget linesillustrate three

prices for food--$2, $1,

and $.50

$2 $1 $0.50

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

A

U2

U3

BDU1

Three separateindifference curves

are tangent toeach budget line.

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

4

5

6

U2

U3

A

BDU1

4 12 20

Three separateindifference curves

are tangent toeach budget line.

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

4

5

6

U2

U3

Price-Consumption Curve

BD

A

U1

4 12 20

The price-consumptioncurve traces out theutility maximizing

market basket for thevarious prices for food.

Effect of a Price Change

Food (units per month)

Priceof Food

$2.00

$1.50

$1.00

$.50

4 12 20

Demand Curve

E

G

H

The points E, G, and Hcorrespond to points

A, B, and D,respectively.

Individual Demand

Two Important Properties of Demand Curves

1) The level of utility that can be attained changes as we move along the

curve.

Individual Demand

Two Important Properties of Demand Curves

2) At every point on the demand curve, the consumer is maximizing utility by

satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing.

Individual Demand

Income Changes

• Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.

Effects of Income Changes

Food (units per month)

3

7

4 10 16

5

Clothing(units per

month)

Effects of Income Changes

Food (units per month)

An increase in income,with the prices fixed,

causes consumers to altertheir choice ofmarket basket.

3

7

4 10 16

5

A U1

Clothing(units per

month)

Effects of Income Changes

Food (units per month)

An increase in income,with the prices fixed,

causes consumers to altertheir choice ofmarket basket.

3

7

4 10 16

5

A U1

BU2

Clothing(units per

month)

Effects of Income Changes

Food (units per month)

An increase in income,with the prices fixed,

causes consumers to altertheir choice ofmarket basket.

3

7

4 10 16

5

A U1

BU2

DU3

Clothing(units per

month)

Effects of Income Changes

Food (units per month)

Clothing(units per

month)

An increase in income,with the prices fixed,

causes consumers to altertheir choice ofmarket basket.

3

7

4 10 16

5

Income-Consumption Curve

A U1

BU2

DU3

Effects of Income Changes

Food (units per month)

Priceof

food

An increase in income,with the prices fixed,shifts the consumer’sdemand curve to the

right. Points E, G andH correspond to A, B, and D on the previous

graph respectively.$1.00

4 10 16

D1

E

Effects of Income Changes

Food (units per month)

Priceof

food

An increase in income,with the prices fixed,shifts the consumer’sdemand curve to the

right. Points E, G andH correspond to A, B, and D on the previous

graph respectively.$1.00

4 10 16

D1

D2

E G

Effects of Income Changes

Food (units per month)

Priceof

food

An increase in income,with the prices fixed,shifts the consumer’sdemand curve to the

right. Points E, G andH correspond to A, B, and D on the previous

graph respectively.$1.00

4 10 16

D1

D2

D3

E G H

Individual Demand

Income Changes

• The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.

Individual Demand

Income Changes

• An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.

• Simultaneously, the increase in income shifts the demand curve to the right.

Individual Demand

Income Changes

• If the income-consumption curve has a positive slope, the quantity demanded increases with income and the income elasticity of demand is positive.

• The good is a normal good.

Individual Demand

Income Changes

• If the income-consumption curve has a negative slope, the quantity demanded decreases with income and the income elasticity of demand is negative.

• The good is an inferior good.

An Inferior Good

Hamburger (units per month)

15

5 10 20

5

Steak(units per

month)

10

30

An Inferior Good

Hamburger (units per month)

15

5 10 20

5

Steak(units per

month)

10

30

AU1

An Inferior Good

Hamburger (units per month)

15

5 10 20

5

Steak(units per

month)

10

30

AU1

B

U2

Both hamburgerand steak behaveas a normal good, between A and B...

An Inferior Good

Hamburger (units per month)

15

5 10 20

5

Steak(units per

month)

10

30

AU1

B

U2

U3

C

…but hamburgerbecomes and inferiorgood when the income

consumption curvebends backward between B and C.

An Inferior Good

Hamburger (units per month)

15

5 10 20

5

Steak(units per

month)

10

30

A

B

U1

B

U2

U3

C

Income-ConsumptionCurve

…but hamburgerbecomes and inferiorgood when the income

consumption curvebends backward between B and C.

Individual Demand

Engel Curves

• Engel curves relate the quantity of good consumed to income.

• If the good is a normal good, the Engel curve is upward sloping.

• If the good is an inferior good, the Engel curve is downward sloping.

Engel Curves

Food (unitsper month)

30

4 8 12

10

Income($ per

month)

20

160

Engel Curves

Food (unitsper month)

30

4 8 12

10

Income($ per

month)

20

16

Engel curves slopeupward for

normal goods.

0

Engel Curves

Hamburger (units per month)

30

5 10

10

Income($ per

month)

20

0

Engel Curves

Hamburger (units per month)

30

5 10

10

Income($ per

month)

20

Engel curves slopebackward bending for inferior goods.

0

Engel Curves

Hamburger (units per month)

30

5 10

10

Income($ per

month)

20

Engel curves slopebackward bending for inferior goods.

0

Inferior

Normal

Example: Consume Expenditures in the United States

Entertainment 520 894 1,185 1,602 2,018 2,565 4,007

Owned Dwellings 854 1,370 2,122 3,314 4,450 5,616 9,736

Rented Dwellings 1,642 2,128 1,978 1,884 1,802 1,514 748

Health Care 1,034 1,647 1,732 1,881 2,012 2,054 2,703

Food 2,461 3,198 3,971 4,706 5,556 6,273 8,137

Clothing 867 1,068 1,394 1,778 2,215 2,316 3,668

Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000-($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above

Income Group (1993 $)

Individual Demand

Substitutes and Complements

1) Two goods are considered substitutes if an increase (decrease)in the price of one leads to an increase (decrease) in the

quantity demanded of the other.– e.g. Butter and margarine

Individual Demand

Substitutes and Complements

2) Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other.

– e.g. CDs and CD players

Individual Demand

Substitutes and Complements

• If the price consumption curve is downward-sloping, the two goods are considered substitutes.

• If the price consumption curve is upward-sloping, the two goods are considered complements.

They could be both!

Income and Substitution Effects

A fall in the price of a good has two effects.

• Consumers experience an increase in real purchasing power.

• They will tend to consume more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.

Income and Substitution Effects

Substitution Effect

• The substitution effect is the change in an item’s consumption associated with a change in the price of the item, with the level of utility held constant.

• When the price of an item declines, the substitution effect always leads to an increase in the quantity of the item demanded.

Income and Substitution Effects

Income Effect

• The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant.

• When a person’s income increases, the quantity demanded for the product may increase or decrease.

– It usually still increases

Income and Substitution Effects

Income Effect

• Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

Income and Substitution Effects--Normal Good

Food (units per month)O

R

Clothing(units per

month)

F1 S

C1

Originally, theconsumer is at A on budget line RS.

A

U1

Income and Substitution Effects--Normal Good

Food (units per month)O

R

Clothing(units per

month)

C2

F1 S F2 T

C1A

U1

When the price of foodfalls, consumption

increases by F1Fs asthe consumer

moves to B.

U2

B

Income and Substitution Effects--Normal Good

Food (units per month)O

R

Clothing(units per

month)

C2

F1 S F2 T

C1A

U1

U2

B

ETotal Effect

SubstitutionEffect

The substitution effect,F1E, (from points AD),

changes the relative pricesbut keeps real income

constant.

D

Income and Substitution Effects--Normal Good

Food (units per month)O

R

Clothing(units per

month)

C2

F1 S F2 T

C1A

U1

The income effect, EF2, (D to B) keeps relative

prices constant but increases purchasing power.

U2

B

ETotal Effect

SubstitutionEffect

Income Effect

D

Income and Substitution Effects--Inferior Good

Food (units per month)O

R

Clothing(units per

month)

F1 S

Originally, theconsumer is at A on budget line RS.

A

U1

Income and Substitution Effects--Inferior Good

Food (units per month)O

R

Clothing(units per

month)

F1 S T

A

U1

E

SubstitutionEffect

The substitution effect,F1E, (from points AD),

changes the relative pricesbut keeps real income

constant.

D

Income and Substitution Effects--Inferior Good

Since food is an inferior good, theincome effect is

negative. However,the substitution effect

is larger than the income effect.

Total Effect

Food (units per month)O

R

Clothing(units per

month)

F1 S F2 T

A

U1

E

SubstitutionEffect

D

B

Income Effect

U2

Income and Substitution Effects

A Special Case--The Giffen Good

• The income effect may theoretically be large enough to cause the demand curve for a good to slope upward.

• This rarely occurs and is of little practical interest.

Market Demand

From Individual to Market Demand

• Market demand curves are the horizontal summation of the individuals’ demand curves.

Determining the Market Demand Curve

1 6 10 1632

2 4 8 1325

3 2 6 1018

4 0 4 711

5 0 2 46

Price Individual A Individual B Individual C Market($) (units) (units) (units) (units)

Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DA

The market demandcurve is obtained by

summing the consumer’s demand curves

Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DA DB

The market demandcurve is obtained by

summing the consumer’s demand curves

Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DA DB DC

The market demandcurve is obtained by

summing the consumer’s demand curves

Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DA DB DC

Market Demand

The market demandcurve is obtained by

summing the consumer’s demand curves

Market Demand

Two Important Points

1) The market demand will shift to the right as more consumers enter

the market.

2) Factors that influence the demands of many consumers will also affect

the market demand.

Market Demand

Point and Arc Elasticities of Demand

• Recall: Price elasticity of demand measures the percentage change in the quantity demanded resulting from a percentage change in price.

PQ

PQ

P/P

Q/Q EP

/

/

Price Elasticity andConsumer Expenditure

If Price Increases, If Price Decreases,

Demand Expenditures Expenditures

Inelastic (Ep<1) Increase Decrease

Unit elastic (Ep=1) Are unchanged Are unchanged

Elastic (Ep>1) Decrease Increase

Market Demand

Point and Arc Elasticities of Demand

• For large price changes (e.g. 20%), the value of elasticity will depend upon where the price and quantity lie on the demand curve.

Market Demand

Point and Arc Elasticities of Demand

• Point elasticity measures elasticity at a point on the demand curve.

• Its formula is:

ope)(P/Q)(1/sl E P

Market Demand

Problems Using Point Elasticity

• We may need to calculate elasticity between two points instead of at a single point.

• The price and quantity used as the original will alter the price elasticity of demand.

• Using different original values will result in different calculations.

Market Demand

Point and Arc Elasticities of Demand

• Arc Elasticity: Arc elasticity uses the average of the initial and final price as the original.

• Its formula is:

)/ QPP)(Q/( E P

Example:The AggregateDemand For Wheat

The demand for U.S. wheat is comprised of domestic demand and export demand.

Example:The AggregateDemand For Wheat

The domestic demand for wheat is given by the equation:

• QDD = 1354 - 70P

The export demand for wheat is given by the equation:

• QDE = 2031 - 209P

Example:The AggregateDemand For Wheat

Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4 to -0.5).

The Aggregate Demandfor Wheat

Quantity (millions of bushels per year)

Price ($/bushel)

02468

101214161820

1000 2000 3000 4000

A

C

B D

DomesticDemand

ExportDemand

The Aggregate Demandfor Wheat

Quantity (millions of bushels per year)

Price ($/bushel)

02468

101214161820

1000 2000 3000 4000

A

C

B D

DomesticDemand

ExportDemand

E

F

Total Demand

Total world demand is the horizontal sum of the domestic demand AB and

export demand CD.

Consumer Surplus

Consumer surplus is the difference between what a consumer is willing to pay for a good and what the consumer actually pays when buying it.

Consumer Surplus

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

14151617181920

Consumer Surplus

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

14151617181920 The consumer surplus

of purchasing 6 concerttickets is the sum of thesurplus derived from each one individually.

Market Price

Consumer Surplus

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

14151617181920

Market Price

ConsumerSurplus

The consumer surplusof purchasing 6 concerttickets is the sum of thesurplus derived from each one individually.

Consumer Surplus

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

14151617181920 The consumer’s

actual expenditureis the price times

the quantity purchased.

Market Price

ActualExpenditure

ConsumerSurplus

Consumer Surplus

The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller.

Consumer Surplus

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

14151617181920 For goods that cannot

be divided into smallparts the consumer surplus

is the yellow areabelow the demand curve.

ActualExpenditure

Demand Curve

Market Price

ConsumerSurplus

Consumer Surplus

Consumer surplus along with aggregate profits allow us to evaluate:

1) Costs and benefits of different market structures

2) Public policies that alter the behavior of consumers and firms

Example:The Value of Clean Air

Air is free in the sense that we need not pay to breathe it.

The Clean Air Act was amended in 1970.

Question: Were the benefits of cleaning up the air worth the costs?

Example:The Value of Clean Air

People pay more to buy houses where the air is clean.

Data for house prices among neighborhoods of Boston and Los Angeles were compared with the various air pollutants.

Valuing Clean Air

NOX (pphm)Pollution Reduction

Value($ per pphm

of reduction)

0

1000

2000

5 10

Valuing Clean Air

NOX (pphm)Pollution Reduction

Value($ per pphm

of reduction)

0

1000

2000

5 10

Valuing Clean Air

NOX (pphm)Pollution Reduction

Value($ per pphm

of reduction)

0

1000

2000

5 10

A

The shaded area gives theconsumer surplus generated

when air pollution is reduced by 5 parts per 100million of nitrous oxide at

a cost of $1000 per part reduced.