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Chapter 4
Individual and Market Demand
Topics to be Discussed
 Individual Demand
 Income and Substitution Effects
 Market Demand
 Consumer Surplus
 Network Externalities
©2005 Pearson Education, Inc.
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Individual Demand
 Price Changes
 The
impact of a change in the price of food
can be illustrated using indifference curves.
 For each price change, we can determine
how much of the good the individual would
purchase given their budget lines and
indifference curves
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Effect of a Price Change
Clothing
Assume:
•I = $20
•PC = $2
•PF = $2, $1, $0.50
10
A
6
U1
5
Each price leads to
different amounts of
food purchased
D
B
4
U3
U2
4
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Chapter 4
Food (units
per month)
4
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
individual
 From the previous
example:
©2005 Pearson Education, Inc.
Chapter 4
Demand Schedule
P
Q
$2.00
20
$1.00
12
$0.50
4
5
Effect of a Price Change
Price
of Food
Individual Demand relates
the quantity of a good that
a consumer will buy to the
price of that good.
E
$2.00
G
$1.00
Demand Curve
$.50
H
4
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Chapter 4
Food (units
per month)
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Effect of a Price Change
Price
of Food
When the price falls:
Pf/Pc & MRS also fall
E
$2.00
•E: Pf/Pc = 2/2 = 1 = MRS
•G: Pf/Pc = 1/2 = .5 = MRS
•H:Pf/Pc = .5/2 = .25 = MRS
G
$1.00
$.50
H
4
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Demand Curve
20
Chapter 4
Food (units
per month)
7
Individual Demand
 Income Changes
The impact of a change in the income can be
illustrated using indifference curves.
Changing income, with prices fixed, causes
consumer to change their market baskets.
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Effects of Income Changes
Clothing
(units per
month)
Assume: Pf = $1, Pc = $2
I = $10, $20, $30
7
D
5
U3
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
U2
B
3
U1
A
4
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Chapter 4
Food (units
per month)
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Individual Demand
 Income Changes
The income-consumption curve traces out
the utility-maximizing combinations of food
and clothing associated with every income
level.
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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.
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Effects of Income Changes
Price
of
food
An increase in income, from
$10 to $20 to $30, with the
prices fixed, shifts the
consumer’s demand curve
to the right as well.
E
$1.00
G
H
D3
D2
D1
4
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Chapter 4
Food (units
per month)
12
Individual Demand
 Income Changes
When the income-consumption curve has a
positive slope:
 The
quantity demanded increases with income.
 The income elasticity of demand is positive.
 The good is a normal good.
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Individual Demand
 Income Changes
When the income-consumption curve has a
negative slope:
 The
quantity demanded decreases with income.
 The income elasticity of demand is negative.
 The good is an inferior good.
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Individual Demand
 Engel Curves
 Engel
curves relate the quantity of good
consumed to income.
 If the good is a normal good, the Engel curve
is upward sloping.
 If the good is an inferior good, the Engel
curve is downward sloping.
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Engel Curves
Income 30
($ per
month)
Engel curves slope
upward for
normal goods.
20
10
4
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Food (units
per month)
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Income and Substitution Effects
 A change in the price of a good has two
effects:
Substitution Effect
Income Effect
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Income and Substitution Effects
 Substitution Effect
Relative price of a good changes when price
changes
Consumers will tend to buy more of the good
that has become relatively cheaper, and less
of the good that is relatively more expensive.
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Income and Substitution Effects
 Income Effect
Consumers experience an increase in real
purchasing power when the price of one
good falls.
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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 demanded of the
good.
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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.
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Income and Substitution Effects
 Income Effect
Even with inferior goods, the income effect is
rarely large enough to outweigh the
substitution effect.
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Income and Substitution
Effects: Normal Good
Clothing
(units per
month) R
When the price of food falls,
consumption increases by F1F2
as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
A
relative prices but keeps real income
(satisfaction) constant.
C1
D
B
C2
U2
Substitution
Effect
O
F1
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Total Effect
The income effect, EF2,
( from D to B) keeps relative
prices constant but
increases purchasing power.
U1
E S
Chapter 4
F2
T
Income Effect
Food (units
per month)
23
Income and Substitution
Effects: Inferior Good
Clothing
(units per
month) R
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.
A
B
U2
D
Substitution
Effect
O
F1
Total Effect
©2005 Pearson Education, Inc.
U1
E S
F2
Chapter
4
Income
Effect
T
Food (units
per month)
24
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.
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Market Demand
 Market Demand Curves
A curve that relates the quantity of a good
that all consumers in a market buy to the
price of that good.
The sum of all the individual demand curves
in the market
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Determining the Market Demand
Curve
Price
A
B
C
Market
Demand
1
6
10
16
32
2
4
8
13
25
3
2
6
10
18
4
0
4
7
11
5
0
2
4
6
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Summing to Obtain a
Market Demand Curve
Price
5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
Market Demand
2
1
0
DA
5
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10
DC
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Chapter 4
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Quantity
28
Market Demand
 From this analysis one can see two
important points
The market demand will shift to the right as
more consumers enter the market.
Factors that influence the demands of many
consumers will also affect the market
demand.
©2005 Pearson Education, Inc.
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Consumer Surplus
 Consumers buy goods because it makes
them better off
 Consumer Surplus measures how much
better off they are
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Consumer Surplus
 Consumer Surplus
The difference between the maximum
amount a consumer is willing to pay for a
good and the amount actually paid.
Can calculate consumer surplus from the
demand curve
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Consumer Surplus - Example
 Student wants to buy concert tickets
 Demand curve tells us willingness to pay
for each concert ticket
1st ticket worth $20 but price is $14 so
student generates $6 worth of surplus
Can measure this for each ticket
Total surplus is addition of surplus for each
ticket purchased
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Consumer Surplus - Example
Price
($ per
ticket)
The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
20
19
18
17
16
15
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 = 21
Market Price
14
13
0
Will not buy more than 7
because surplus is
negative
1
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Chapter 4
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Rock Concert Tickets
33
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 is area under the
demand curve and above the price
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Consumer Surplus
Price
($ per
ticket)
Consumer Surplus
for the Market Demand
20
19
CS = ½ ($20 - $14)*(1600)
= $19,500
18
17
16
15
Consumer
Surplus
Market Price
14
13
Demand Curve
Actual
Expenditure
0
1
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3
4
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6
Rock Concert Tickets
35
Network Externalities
 Up to this point we have assumed that
people’s demands for a good are
independent of one another.
 For some goods, one person’s demand
also depends on the demands of other
people
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Network Externalities
 If this is the case, a network externality
exists.
 Network externalities can be positive or
negative.
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Network Externalities
 A positive network externality exists if the
quantity of a good demanded by a
consumer increases in response to an
increase in purchases by other
consumers.
 Negative network externalities are just
the opposite.
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Network Externalities
 The Bandwagon Effect
This is the desire to be in style, to have a
good because almost everyone else has it,
or to indulge in a fad.
This is the major objective of marketing and
advertising campaigns (e.g. toys, clothing).
Positive network externality in which a
consumer wishes to possess a good in part
because others do
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Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right .
Quantity
20
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Chapter 4
80
100
(thousands per month)
40
Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
The market demand
curve is found by joining
the points on the individual
demand curves. It is relatively
more elastic.
Demand
Quantity
20
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Chapter 4
80
100
(thousands per month)
41
Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
$30
Suppose
the price
fallsbuy
But as more
people
fromthe
$30
to $20.
If there
good,
it becomes
werestylish
no bandwagon
effect,
to own it and
quantity
demanded
would
the quantity
demanded
only increase
tofurther.
48,000
increases
Demand
$20
Bandwagon
Effect
Pure Price
Effect
Quantity
20
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Chapter 4
80
100
(thousands per month)
42
Network Externalities
 The Snob Effect
If the network externality is negative, a snob
effect exists.
 The snob effect refers to the desire to
own exclusive or unique goods.
 The quantity demanded of a “snob” good
is higher the fewer the people who own it.
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Network Externality: Snob Effect
Price
($ per
unit)
Demand
$30,000
Originally demand is D2,
when consumers think 2000
people have bought a good.
However, if consumers think 4,000
people have bought the good,
demand shifts from D2 to D6 and its
snob value has been reduced.
$15,000
D2
Pure Price Effect
D4
D8
2
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Chapter 4
D6
Quantity
14
(thousands
per month)
44
Network Externality: Snob Effect
Price
($ per
unit)
The demand is less elastic and
as a snob good its value is greatly
reduced if more people own
it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.
Demand
$30,000
Net Effect
Snob Effect
$15,000
D2
Pure Price Effect
D4
D8
2
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D6
Quantity
14
(thousands
per month)
45