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Chapter 4
Individual and Market Demand
2
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Empirical Estimation of Demand
3
Effect of a Price Change
Each price leads to different amounts of
food purchased5
U3
D
4
U2
B
12 20
Assume: • I = $20• PC = $2• PF = $2, $1, $0.50
Food (units per month)
Clothing
6 A
U1
4
10
4
Effect of a Price Change
The Price-Consumption Curve traces out the utility maximizing market
basket for each price of food
4
U2
B
12 20
5
U3
D
Food (units per month)
Clothing
6 A
U1
4
10
5
Effect of a Price Change
By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individualFrom the previous example:
Demand Schedule
20$0.50
12$1.00
4$2.00
QP
6
Effect of a Price Change
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50Demand Curve
• E: Pf /Pc = 2/2 = 1 = MRS• G: Pf /Pc = 1/2 = .5 = MRS• H:Pf /Pc = .5/2 = .25 = MRS
When the price falls, Pf /Pc & MRS also fall
7
Substitutes & Complements
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 otherTwo goods are considered complementsif an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other
8
Substitutes & Complements
If the price consumption curve is downward-sloping, the two goods are considered substitutesIf the price consumption curve is upward-sloping, the two goods are considered complementsThey could be both
9
Individual Demand
Income ChangesUsing the figures developed in the previous chapter, the impact of a change in the income can be illustrated using indifference curvesChanging income, with prices fixed, causes consumers to change their market baskets
10
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
4
A U1
5
10
BU2
D7
16
U3
Assume: Pf = $1, Pc = $2I = $10, $20, $30
11
Effects of Income Changes
Food (units per month)
Clothing(units per
month)The Income Consumption Curve traces out the utility maximizing market basket for each income level
3
4
A U1
5
10
BU2
D7
16
U3
Income Consumption Curve
12
Effects of Income Changes
Food (units per month)
Priceof
foodAn increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right as well.
$1.00
4
D1
E
10
D2
G
16
D3
H
13
An Inferior Good
Hamburger(units per month)
Steak(units per
month)
30
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes an inferior
good when the incomeconsumption curvebends backward between B and C.
105
AU1
5
20
10
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
14
Individual Demand
Engel CurvesEngel curves relate the quantity of good consumed to incomeIf the good is a normal good, the Engel curve is upward slopingIf the good is an inferior good, the Engel curve is downward sloping
15
Engel Curves
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Engel curves slopeupward for
normal goods.
16
Engel Curves
Engel curves arebackward bendingfor inferior goods.
Inferior
Normal
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
17
Annual US Household Consumer Expenditures
18
Income and Substitution Effects
A change in the price of a good has two effects:
Substitution EffectIncome Effect
19
Income and Substitution Effects
Substitution EffectConsumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive.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 constantWhen the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good
20
Income and Substitution Effects
Income EffectConsumers experience an increase in real purchasing power when the price of one good fallsThe 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 constantWhen a person’s income increases, the quantity demanded for the product may increase or decrease
21
Income and SubstitutionEffects: Normal Good
Food (units per month)O
Clothing(units per
month) R
F1 S
C1 A
U1
The income effect, EF2, (from D to B) keeps relativeprices constant but increases purchasing power.
Income Effect
C2
F2 T
U2
B
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.
ETotal Effect
SubstitutionEffect
D
The substitution effect, F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.
22
Food (units per month)O
R
Clothing(units per
month)
F1 S F2 T
A
U1
E
SubstitutionEffect
D
Total Effect
Since food is an inferior good, theincome effect is
negative. However,the substitution effect
is larger than the income effect.
B
Income Effect
U2
Income and SubstitutionEffects: Inferior Good
23
Income and Substitution Effects
A Special Case: The Giffen GoodThe income effect may theoretically be large enough to cause the demand curve for a good to slope upwardThis rarely occurs and is of little practical interest
24
Market Demand
Market Demand CurvesA curve that relates the quantity of a good that all consumers in a market buy to the price of that goodThe sum of all the individual demand curves in the market
25
Determining the Market Demand Curve
64205
117404
1810623
2513842
32161061
Market DemandCBAPrice
26
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DB DC
Market Demand
DA
The market demandcurve is obtained by
summing the consumer’s demand curves
27
Market Demand
Aggregation is important to be able to discuss regarding demand for different groups
Households with childrenConsumers aged 20 – 30, etc.
28
Market Demand
Price Elasticity of DemandMeasures the percentage change in the quantity demanded resulting from a percent change in price
QP
PQ
P/PQ/Q
P%Q% EP
∆∆
=∆∆
=∆∆
=
29
Price Elasticity of Demand
Inelastic DemandEp is less than 1 in absolute valueQuantity demanded is relatively unresponsive to a change in price|%∆Q| < |%∆P|Total expenditure (P*Q) increases when price increases
30
Price Elasticity of Demand
Elastic DemandEp is greater than than 1 in absolute valueQuantity demanded is relatively responsive to a change in price|%∆Q| > |%∆P|Total expenditure (P*Q) decreases when price increases
31
Price Elasticity of Demand
Isoelastic DemandWhen price elasticity of demand is constant along the entire demand curveDemand curve is bowed inward (not linear)
32
The Aggregate Demand for Wheat
The demand for US wheat is comprised of two components: domestic demand export demandThe domestic demand for wheat is given by the equation:
QDD = 1465 - 88PThe export demand for wheat is given by the equation:
QDE = 1344 - 138P
33
The Aggregate Demand for Wheat
Domestic demand is relatively price inelastic (Ed = -0.2)Export demand is more price elastic (Ed = -0.4)
Poorer countries that import US wheat turn to other grains and food if wheat prices increase
34
C
D
ExportDemand
Total world demand is the horizontal sum of the domestic demand AB and
export demand CD.
F
Total Demand
A
B
DomesticDemand
E
The Aggregate Demand for Wheat
Wheat
Price
0
10
16
18
Above C, export demand is zero, so domestic demand = total demand = AE segment
35
Consumer Surplus
Consumers buy goods because it makes them better offConsumer Surplus measures how much better off they are
36
Consumer Surplus
Consumer SurplusConsumers buy goods because it makes them better off The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paidCan calculate consumer surplus from the demand curve
37
Consumer Surplus - Example
Student wants to buy concert ticketsDemand curve tells us willingness to pay for each concert ticket
1st ticket worth $20 but price is $14 so student generates $6 worth of surplusCan measure this for each ticketTotal surplus is addition of surplus for each ticket purchased
38
Demand Curve
ConsumerSurplus
Consumer Surplusfor the Market Demand
Consumer Surplus
Rock Concert Tickets
Price($ perticket)
2 3 4 5 6
13
0 1
ActualExpenditure
14151617181920
Market Price
CS = ½ ($20 - $14)*(1600) = $19,500
39
Applying Consumer Surplus
Combining consumer surplus with the aggregate profits that producers obtain, we can evaluate:
1. Costs and benefits of different market structures
2. Public policies that alter the behavior of consumers and firms
Total benefits would be compared to total costs to determine if the clean up was worthwhile
40
Applying Consumer Surplus –An Example
The Value of Clean AirAir is free in the sense that we don’t pay to breathe itThe Clean Air Act was amended in 1970Question: Were the benefits of cleaning up the air worth the costs?
41
The Value of Clean Air
Empirical data determined estimates for the demand for clean airNo market exists for clean air, but can see people are willing to pay for it
Ex: People pay more to buy houses where the air is clean
42
The shaded area represents theconsumer surplus generated
when air pollution is reduced by 5 parts per 100million of nitrous oxide at
a cost of $1000 per part reduced.
Valuing Cleaner Air
2000
100
1000
5
A
NOX (pphm)Pollution Reduction
Value
43
Network Externalities
Up to this point we have assumed that people’s demands for a good are independent of one anotherFor some goods, one person’s demand also depends on the demands of other peopleIf this is the case, a network externalityexists
44
Network Externalities
A positive network externality exists if the quantity of a good demanded by a consumer increases in response to an increase in purchases by other consumers
Negative network externalities are just the opposite
45
Network Externalities
The Bandwagon EffectThis is the desire to be in style, to have a good because almost everyone else has it, or to indulge in a fadThis is the major objective of marketing and advertising campaigns (e.g. toys, clothing)Positive network externality in which a consumer wishes to possess a good in part because others do
46
Positive NetworkExternality: Bandwagon Effect
Quantity(thousands per month)
Price($ per
unit)
D20
20
When consumers believe more people have purchased theproduct, the demand curve shifts further to the the right.
40
D40
60
D60
80
D80
100
D100
47
Positive NetworkExternality: Bandwagon Effect
Quantity(thousands per month)
Price($ per
unit)
D20
20
Suppose the price fallsfrom $30 to $20. If there were no bandwagon effect,quantity demanded wouldonly increase to 48,000
40
D40
60
D60
80
D80
100
D100
Demand
But as more people buythe good, it becomes stylish to own it and
the quantity demandedincreases further.
$30
48
$20
Pure PriceEffect
BandwagonEffect
48
Network Externalities
The Snob EffectIf the network externality is negative, a snob effect exists
The snob effect refers to the desire to own exclusive or unique goodsThe quantity demanded of a “snob” good is higher the fewer the people who own it
49
Network Externality: Snob Effect
Quantity (thousandsper month)
Price($ per
unit)
2
Demand
D2
$30,000
$15,000
144 6 8
D4
D6D8
Pure Price Effect
The demand is less elastic and as a snob good its value is greatly
reduced if more people ownit. Sales decrease as a result.
Examples: Rolex watches and longlines at the ski lift.
Net Effect Snob Effect
50
Empirical Estimation of Demand
The most direct way to obtain information about demand is through interviews where consumers are asked how much of a product they would be willing to buy at a given priceProblem
Consumers may lack information or interest, or be misled by the interviewer
51
Empirical Estimation of Demand
The Statistical Approach to Demand Estimation
Properly applied, the statistical approach to demand estimation can enable one to sort out the effects of variables on the quantity demanded of a product“Least-squares” regression is one approach
52
Demand Data for Raspberries
53
Estimating Demand
Quantity
Price
0 5 10 15 20 25
15
10
5
25
20
d1
d2
d3
D
D represents demandif only P determinesdemand and then from the data: Q=28.2-1.00P
54
Empirical Estimation of Demand
Substitutes: b2 is positiveComplements: b2 is negative
)log(log)log()log( 22 IcPbPbaQ ++−=
Complements and Substitutes
55
The Demand for Ready-to-Eat Cereal
Are Grape Nuts and Spoon Size Shredded Wheat good substitutes?
Estimated demand for Grape Nuts (GN)
)log(14.0)log(62.0)log(085.2998.1)log( SWGNGN PIPQ ++−=
Price elasticity = -2.0Income elasticity = 0.62Cross elasticity = 0.14