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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

Empirical Estimation of Demand
Chapter 4
Slide 2
Individual Demand

Price Changes

Chapter 4
Using the figures developed in the
previous chapter, the impact of a
change in the price of food can be
illustrated using indifference curves.
Slide 3
Effect of a Price Change
Clothing
(units per
month)
Assume:
•I = $20
•PC = $2
•PF = $2, $1, $.50
10
A
6
U1
5
D
B
U3
4
Three separate
indifference curves
are tangent to
each budget line.
U2
4
Chapter 4
12
20
Food (units
per month)
Slide 4
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
Chapter 4
12
20
Food (units
per month)
Slide 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
Chapter 4
12
20
Food (units
per month)
Slide 6
Individual Demand
The Individual Demand Curve

Two Important Properties of Demand
Curves
1) The level of utility that can be
attained changes as we move
along the curve.
Chapter 4
Slide 7
Individual Demand
The Individual Demand Curve

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.
Chapter 4
Slide 8
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
Demand Curve
$.50
H
4
Chapter 4
12
20
Food (units
per month)
Slide 9
Individual Demand

Income Changes

Chapter 4
Using the figures developed in the
previous chapter, the impact of a
change in the income can be illustrated
using indifference curves.
Slide 10
Effects of Income Changes
Clothing
(units per
month)
Assume: Pf = $1
Pc = $2
I = $10, $20, $30
Income-Consumption
Curve
7
D
5
U2
B
3
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
U1
A
4
Chapter 4
U3
10
16
Food (units
per month)
Slide 11
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.
E
$1.00
G
H
D3
D2
D1
4
Chapter 4
10
16
Food (units
per month)
Slide 12
Individual Demand

Income Changes
 The
income-consumption curve traces
out the utility-maximizing combinations
of food and clothing associated with
every income level.
Chapter 4
Slide 13
Individual Demand

Income Changes

An increase in income shifts the budget
line to the right, increasing consumption
along the income-consumption curve.

Simultaneously, the increase in income
shifts the demand curve to the right.
Chapter 4
Slide 14
Individual Demand
Normal Good vs. Inferior Good

Income Changes

Chapter 4
When the income-consumption curve
has a positive slope:
 The quantity demanded increases
with income.
 The income elasticity of demand is
positive.
 The good is a normal good.
Slide 15
Individual Demand
Normal Good vs. Inferior Good

Income Changes

Chapter 4
When the income-consumption curve
has a negative slope:
 The quantity demanded decreases
with income.
 The income elasticity of demand is
negative.
 The good is an inferior good.
Slide 16
An Inferior Good
Steak 15
(units per
month)
Income-Consumption
Curve
C
10
Both hamburger
and steak behave
as a normal good,
between A and B...
U3
B
5
U2
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C.
A
U1
5
Chapter 4
10
20
Hamburger
30 (units per month)
Slide 17
Individual Demand

Engel Curves

Engel curves relate the quantity of good
consumed to income.

If the good is a normal good, the Engel
curve is upward sloping.

If the good is an inferior good, the Engel
curve is downward sloping.
Chapter 4
Slide 18
Engel Curves
Income
($ per
month) 30
Engel curves slope
upward for
normal goods.
20
10
0
Chapter 4
4
8
12
16
Food (units
per month)
Slide 19
Engel Curves
Income
($ per
month) 30
Inferior
Engel curves slope
backward bending
for inferior goods.
20
Normal
10
0
Chapter 4
4
8
12
16
Food (units
per month)
Slide 20
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.

Chapter 4
e.g. movie tickets and video rentals
Slide 21
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.

Chapter 4
e.g. gasoline and motor oil
Slide 22
Individual Demand
Substitutes and Complements
3) Two goods are independent when a
change in the price of one good has
no effect on the quantity demanded
of the other
Chapter 4
Slide 23
Income and Substitution Effects

A fall in the price of a good has two
effects: Substitution & Income

Substitution Effect

Chapter 4
Consumers will tend to buy more of
the good that has become relatively
cheaper, and less of the good that is
now relatively more expensive.
Slide 24
Income and Substitution Effects

A fall in the price of a good has two
effects: Substitution & Income

Income Effect
Consumers
experience an increase
in real purchasing power when the
price of one good falls, thus
increasing consumption.
Chapter 4
Slide 25
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.
Chapter 4
Slide 26
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.
Chapter 4
Slide 27
Income and Substitution Effects

Income Effect

Even with inferior goods, the income
effect is rarely large enough to outweigh
the substitution effect.
Chapter 4
Slide 28
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
Chapter 4
F1
Total Effect
The income effect, EF2,
( from D to B) keeps relative
prices constant but
increases purchasing power.
U1
E
S
F2
T
Income Effect
Food (units
per month)
Slide 29
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
F2
Total Effect
Chapter 4
U1
E
S
T
Food (units
per month)
Income Effect
Slide 30
Market Demand
From Individual to 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.
Chapter 4
Slide 31
Determining the
Market Demand Curve
Price Individual A Individual B Individual C Market
($)
(units)
(units)
(units)
(units)
1
6
10
16
32
2
4
8
13
25
3
2
6
10
18
4
0
4
7
11
5
0
2
4
6
Chapter 4
Slide 32
Summing to Obtain a
Market Demand Curve
Price
5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
Market Demand
2
1
0
Chapter 4
DA
5
DB
10
DC
15
20
25
30
Quantity
Slide 33
Market Demand

Two Important Points
1) The market demand will shift to
the right as more consumers
enter
the market.
2) Factors that influence the
demands of many consumers will
also affect the market demand.
Chapter 4
Slide 34
Market Demand

Elasticity of Demand
Recall: Price elasticity of demand
measures the percentage change in the
quantity demanded resulting from a
1-percent change in price.
Q/Q Q / P
EP 

P/P
Q/P
Chapter 4
Slide 35
Price Elasticity and
Consumer Expenditure
Demand
Inelastic (Ep <1)
If Price Increases,
Expenditures:
Increase
If Price Decreases,
Expenditures:
Decrease
Unit Elastic (Ep = 1) Are unchanged
Are unchanged
Elastic (Ep >1)
Increase
Chapter 4
Decrease
Slide 36
Market Demand

Point Elasticity of Demand

Chapter 4
For large price changes (e.g. 20%), the
value of elasticity will depend upon
where the price and quantity lie on the
demand curve.
Slide 37
Market Demand

Point Elasticity of Demand

Point elasticity measures elasticity at a
point on the demand curve.

Its formula is:
EP  (P/Q)(1/sl ope)
Chapter 4
Slide 38
Market Demand

Problems Using Point Elasticity

We may need to calculate price
elasticity over portion of the demand
curve rather than at a single point.

The price and quantity used as the base
will alter the price elasticity of demand.
Chapter 4
Slide 39
Market Demand
Point Elasticity of Demand (An Example)

Assume

Price increases from 8$ to $10, quantity
demanded falls from 6 to 4

Percent change in price equals:
$2/$8 = 25% or $2/$10 = 20%

Percent change in quantity equals:
-2/6 = -33.33% or -2/4 = -50%
Chapter 4
Slide 40
Market Demand
Point Elasticity of Demand (An Example)

Elasticity equals:
-33.33/.25 = -1.33 or -.50/.20 = -2.54

Which one is correct?
Chapter 4
Slide 41
Market Demand

Arc Elasticity of Demand

Arc elasticity calculates elasticity over a
range of prices

Its formula is:
EP  ( Q/P)( P / Q)
P  the average price
Q  the average quantity
Chapter 4
Slide 42
Market Demand

Arc Elasticity of Demand (An Example)
EP  ( Q/ P)( P / Q)
P  8, P  10, Q  6, Q  4
P  18 / 2  9 & Q  10 / 2  5
E  (2 / $2)($9 / 5)  1.8
1
2
1
2
p
Chapter 4
Slide 43
Consumer Surplus

Consumer Surplus
 The
difference between the maximum
amount a consumer is willing to pay for
a good and the amount actually paid.
Chapter 4
Slide 44
Consumer Surplus
Price
($ 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
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 = 21
Market Price
14
13
0
Chapter 4
1
2
3
4
5
6
Rock Concert Tickets
Slide 45
Consumer Surplus

The stepladder demand curve can be
converted into a straight-line demand
curve by making the units of the good
smaller.
Chapter 4
Slide 46
Consumer Surplus
Price
($ per
ticket)
Consumer Surplus
for the Market Demand
20
19
18
17
16
15
Consumer
Surplus
1/2x(20  14)x6,500  $19,500
Market Price
14
13
Demand Curve
Actual
Expenditure
0
Chapter 4
1
2
3
4
5
6
Rock Concert Tickets
Slide 47
Network Externalities

Up to this point we have assumed
that people’s demands for a good are
independent of one another.

If fact, a person’s demand may be
affected by the number of other
people who have purchased the
good.
Chapter 4
Slide 48
Network Externalities

If this is the case, a network
externality exists.

Network externalities can be positive
or negative.
Chapter 4
Slide 49
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.
Chapter 4
Slide 50
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).
Chapter 4
Slide 51
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.
Chapter 4
Slide 52
Empirical Estimation of Demand

The Statistical Approach to Demand
Estimation

Surveys

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.
Chapter 4
Slide 53
Summary

Individual consumers’ demand
curves for a commodity can be
derived from information about their
tastes for all goods and services and
from their budget constraints.

Engel curves describe the
relationship between the quantity of a
good consumed and income.
Chapter 4
Slide 54
Summary

Two goods are substitutes if an
increase in the price of one good
leads to an increase in the quantity
demanded of the other. They are
complements if the quantity
demanded of the other declines.
Chapter 4
Slide 55
Summary

Two goods are substitutes if an increase in
the price of one good leads to an increase
in the quantity demanded of the other.
They are complements if the quantity
demanded of the other declines.

The effect of a price change on the
quantity demanded can be broken into a
substitution effect and an income effect.
Chapter 4
Slide 56
Summary

The market demand curve is the
horizontal summation of the
individual demand curves for all
consumers.

The percent change in quantity
demanded that results from a one
percent change in price determines
elasticity of demand.
Chapter 4
Slide 57
Summary

There is a network externality when
one person’s demand is affected
directly by the purchasing decisions
of other consumers.

A number of methods can be used to
obtain information about consumer
demand.
Chapter 4
Slide 58
End of Chapter 4