Download Prch4

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 utilitymaximizing 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
Clothing
(units per
month)
Food (units
per month)
Effect of a Price Change
Clothing
(units per
month)
The budget lines
illustrate three
prices for
food--$2
$2
Food (units
per month)
Effect of a Price Change
Clothing
(units per
month)
The budget lines
illustrate three
prices for
food--$2, $1,
$2
$1
Food (units
per month)
Effect of a Price Change
Clothing
(units per
month)
The budget lines
illustrate three
prices for
food--$2, $1,
and $.50
$2
$1
$0.50
Food (units
per month)
Effect of a Price Change
Clothing
(units per
month)
Three separate
indifference curves
are tangent to
each budget line.
A
U1
D
B
U3
U2
Food (units
per month)
Effect of a Price Change
Clothing
(units per
month)
Three separate
indifference curves
are tangent to
each budget line.
A
6
U1
5
D
B
U3
4
U2
4
12
20
Food (units
per month)
Effect of a Price Change
The price-consumption
curve traces out the
utility maximizing
market basket for the
various prices for food.
Clothing
(units per
month)
A
6
Price-Consumption Curve
U1
5
D
B
U3
4
U2
4
12
20
Food (units
per month)
Effect of a Price Change
Price
of Food
The points E, G, and H
correspond to points
A, B, and D,
respectively.
E
$2.00
$1.50
G
$1.00
Demand Curve
$.50
H
4
12
20
Food (units
per month)
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
Clothing
(units per
month)
7
5
3
4
10
16
Food (units
per month)
Effects of Income Changes
Clothing
(units per
month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
7
5
3
A
4
U1
10
16
Food (units
per month)
Effects of Income Changes
Clothing
(units per
month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
7
5
U2
B
3
A
4
U1
10
16
Food (units
per month)
Effects of Income Changes
Clothing
(units per
month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
7
D
5
U3
U2
B
3
A
4
U1
10
16
Food (units
per month)
Effects of Income Changes
Clothing
(units per
month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
7
D
5
Income-Consumption
Curve
U3
U2
B
3
A
4
U1
10
16
Food (units
per month)
Effects of Income Changes
Price
of
food
An increase in income,
with the prices fixed,
shifts the consumer’s
demand curve to the
right. Points E, G and
H correspond to A, B,
and D on the previous
graph respectively.
E
$1.00
D1
4
10
16
Food (units
per month)
Effects of Income Changes
Price
of
food
E
$1.00
An increase in income,
with the prices fixed,
shifts the consumer’s
demand curve to the
right. Points E, G and
H correspond to A, B,
and D on the previous
graph respectively.
G
D2
D1
4
10
16
Food (units
per month)
Effects of Income Changes
Price
of
food
E
$1.00
G
An increase in income,
with the prices fixed,
shifts the consumer’s
demand curve to the
right. Points E, G and
H correspond to A, B,
and D on the previous
graph respectively.
H
D3
D2
D1
4
10
16
Food (units
per month)
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
Steak 15
(units per
month)
10
5
5
10
20
30
Hamburger
(units per month)
An Inferior Good
Steak 15
(units per
month)
10
5
A
U1
5
10
20
30
Hamburger
(units per month)
An Inferior Good
Steak 15
(units per
month)
Both hamburger
and steak behave
as a normal good,
between A and B...
10
B
5
U2
A
U1
5
10
20
30
Hamburger
(units per month)
An Inferior Good
Steak 15
(units per
month)
…but hamburger
becomes and inferior
good when the income
consumption curve
bends backward
between B and C.
C
10
U3
B
5
U2
A
U1
5
10
20
30
Hamburger
(units per month)
An Inferior Good
Steak 15
(units per
month)
Income-Consumption
Curve
C
10
U3
…but hamburger
becomes and inferior
good when the income
consumption curve
bends backward
between B and C.
B
5
B
U2
A
U1
5
10
20
30
Hamburger
(units per month)
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
Income
($ per 30
month)
20
10
0
4
8
12
16
Food (units
per month)
Engel Curves
Income
($ per 30
month)
Engel curves slope
upward for
normal goods.
20
10
0
4
8
12
16
Food (units
per month)
Engel Curves
Income
($ per 30
month)
20
10
0
5
10
Hamburger
(units per month)
Engel Curves
Income
($ per 30
month)
Engel curves slope
backward bending
for inferior goods.
20
10
0
5
10
Hamburger
(units per month)
Engel Curves
Income
($ per 30
month)
Inferior
Engel curves slope
backward bending
for inferior goods.
20
Normal
10
0
5
10
Hamburger
(units per month)
Example: Consume Expenditures
in the United States
Income Group (1993 $)
Expenditure
($) on:
Less than
$10,000
1,00019,000
20,00029,000
30,000- 40,00039,000 49,000
50,000- 70,00069,000 and above
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
867
1,068
1,394
1,778
2,215
2,316
3,668
Clothing
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 downwardsloping, the two goods are considered
substitutes.
•
If the price consumption curve is upwardsloping, 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
Clothing
(units per
month) R
Originally, the
consumer is at A
on budget line RS.
A
C1
U1
O
F1
S
Food (units
per month)
Income and Substitution Effects-Normal Good
Clothing
(units per
month) R
When the price of food
falls, consumption
increases by F1Fs as
the consumer
moves to B.
A
C1
B
C2
U2
U1
O
F1
S
F2
T
Food (units
per month)
Income and Substitution Effects-Normal Good
Clothing
(units per
month) R
The substitution effect,F1E,
(from points AD),
changes the relative prices
but keeps real income
constant.
A
C1
D
C2
B
Substitution
Effect
O
F1
Total Effect
U2
U1
E S
F2
T
Food (units
per month)
Income and Substitution Effects-Normal Good
Clothing
(units per
month) R
The income effect, EF2,
(D to B) keeps relative
prices constant but
increases purchasing power.
A
C1
D
C2
B
Substitution
Effect
O
F1
Total Effect
U2
U1
E S
F2
T
Income Effect
Food (units
per month)
Income and Substitution Effects-Inferior Good
Clothing
(units per
month) R
Originally, the
consumer is at A
on budget line RS.
A
U1
O
F1
S
Food (units
per month)
Income and Substitution Effects-Inferior Good
Clothing
(units per
month) R
The substitution effect,F1E,
(from points AD),
changes the relative prices
but keeps real income
constant.
A
D
Substitution
Effect
O
F1
U1
E S
T
Food (units
per month)
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
U1
E S
F2
Income Effect
T
Food (units
per month)
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
Price Individual A
($)
(units)
Individual B
(units)
Individual C
(units)
Market
(units)
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
Summing to Obtain a
Market Demand Curve
Price 5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
2
1
D
A
0
5
10
15
20
25
30
Quantity
Summing to Obtain a
Market Demand Curve
Price 5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
2
1
D
DB
A
0
5
10
15
20
25
30
Quantity
Summing to Obtain a
Market Demand Curve
Price 5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
2
1
D
DB
D
A
0
5
C
10
15
20
25
30
Quantity
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
D
DB
D
A
0
5
C
10
15
20
25
30
Quantity
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.
Q/Q Q / P
EP 

P/P
Q/P
Price Elasticity and
Consumer Expenditure
Demand
If Price Increases,
Expenditures
If Price Decreases,
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:
EP  (P/Q)(1/sl ope)
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:
EP  ( Q/P)( P / Q )
Example:The Aggregate
Demand For Wheat

The demand for U.S. wheat is comprised of
domestic demand and export demand.
Example:The Aggregate
Demand 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 Aggregate
Demand For Wheat

Domestic demand is relatively price
inelastic (-0.2), while export demand is
more price elastic (-0.4 to -0.5).
The Aggregate Demand
for Wheat
Price
($/bushel)
20 A
18
16
14
12
10 C
8
Export
6
Demand
Domestic
4 Demand
2
B
D
0
1000
2000
3000
4000
Quantity (millions of bushels per year)
The Aggregate Demand
for Wheat
Price
($/bushel)
Total world demand is
20 A
the horizontal sum of the
domestic demand AB and
18
export demand CD.
16
Total Demand
14
12
E
C
10
8
Export
6
Demand
Domestic
4 Demand
2
B
D
F
0
1000
2000
3000
4000
Quantity (millions of bushels per year)
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
Price
($ per
ticket)
20
19
18
17
16
15
14
13
0
1
2
3
4
5
6
Rock Concert Tickets
Consumer Surplus
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
14
13
0
Market Price
1
2
3
4
5
6
Rock Concert Tickets
Consumer Surplus
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
14
13
0
Consumer
Surplus
1
2
3
Market Price
4
5
6
Rock Concert Tickets
Consumer Surplus
Price
($ per
ticket)
The consumer’s
actual expenditure
is the price times
the quantity purchased.
20
19
18
17
16
15
14
13
Consumer
Surplus
Market Price
Actual
Expenditure
0
1
2
3
4
5
6
Rock Concert Tickets
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
Price
($ per
ticket)
For goods that cannot
be divided into small
parts the consumer surplus
is the yellow area
below the demand curve.
20
19
18
17
16
15
14
13
Consumer
Surplus
Market Price
Demand Curve
Actual
Expenditure
0
1
2
3
4
5
6
Rock Concert Tickets
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
Value
($ per pphm 2000
of reduction)
1000
0
5
NOX (pphm)
10 Pollution
Reduction
Valuing Clean Air
Value
($ per pphm 2000
of reduction)
1000
0
5
NOX (pphm)
10 Pollution
Reduction
Valuing Clean Air
Value
($ per pphm 2000
of reduction)
A
1000
0
5
The shaded area gives the
consumer surplus generated
when air pollution is
reduced by 5 parts per 100
million of nitrous oxide at
a cost of $1000 per
part reduced.
NOX (pphm)
10 Pollution
Reduction