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Topics to be Discussed

Individual Demand

Income and Substitution Effects

Market Demand

Consumer Surplus

Empirical Estimation of Demand
Lecture 4
Slide 1
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
Lecture 4
12
20
Food (units
per month)
Slide 2
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
Lecture 4
12
20
Food (units
per month)
Slide 3
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
Lecture 4
12
20
Food (units
per month)
Slide 4
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
Lecture 4
U3
10
16
Food (units
per month)
Slide 5
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
Lecture 4
10
16
Food (units
per month)
Slide 6
Individual Demand
Normal Good vs. Inferior Good

Income Changes

Lecture 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 7
Individual Demand
Normal Good vs. Inferior Good

Income Changes

Lecture 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 8
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
Lecture 4
10
20
Hamburger
30 (units per month)
Slide 9
Consumer Expenditures
in the United States
Income Group (1997 $)
Expenditure
($) on:
Less than 1,000$10,000 19,000
Entertainment
20,00029,000
30,000- 40,00039,000 49,000
50,000- 70,00069,000 and above
700
947
1274
1514
2054
2654
4300
Owned Dwellings 1116
1725
2253
3243
4454
5793
9898
Rented Dwellings1957
2170
2371
2536
2137
1540
1266
Health Care
1031
1697
1918
1820
2052
2214
2642
Food
2656
3385
4109
4888
5429
6220
8279
859
978
1363
1772
1778
2614
3442
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.

Lecture 4
e.g. movie tickets and video rentals
Slide 11
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.

Lecture 4
e.g. gasoline and motor oil
Slide 12
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
Lecture 4
Slide 13
Income and Substitution Effects

A fall in the price of a good has two
effects: Substitution & Income

Substitution Effect

Lecture 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 14
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.
Lecture 4
Slide 15
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.
Lecture 4
Slide 16
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.
Lecture 4
Slide 17
Income and Substitution Effects

Income Effect

Lecture 4
Even with inferior goods, the income
effect is rarely large enough to outweigh
the substitution effect.
Slide 18
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
Lecture 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 19
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
E
Total Effect
Lecture 4
U1
S
F2
T
Food (units
per month)
Income Effect
Slide 20
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.
Lecture 4
Slide 21
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.
Lecture 4
Slide 22
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
Lecture 4
Slide 23
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
Lecture 4
DA
5
DB
10
DC
15
20
25
30
Quantity
Slide 24
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)
Lecture 4
Slide 25
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.
Lecture 4
Slide 26
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%
Lecture 4
Slide 27
Market Demand
Point Elasticity of Demand (An Example)

Elasticity equals:
-33.33/.25 = -1.33 or -.50/.20 = -2.54

Which one is correct?
Lecture 4
Slide 28
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
Lecture 4
Slide 29
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)($9 / 5)  1.8
1
2
1
2
p
Lecture 4
Slide 30
An Example:
The Aggregate Demand For Wheat

The demand for U.S. wheat is
comprised of domestic demand and
export demand.
Lecture 4
Slide 31
The Aggregate Demand For Wheat

The domestic demand for wheat is
given by the equation:


QDD = 1700 - 107P
The export demand for wheat is
given by the equation:

Lecture 4
QDE = 1544 - 176P
Slide 32
The Aggregate Demand For Wheat

Domestic demand is relatively price
inelastic (-0.2), while export demand
is more price elastic (-0.4).
Lecture 4
Slide 33
The Aggregate Demand For Wheat
Price
($/bushel)
20
18
16
Total world demand is
the horizontal sum of the
domestic demand AB and
export demand CD.
A
14
12
10
C
E
8
Total Demand
6
4
Export
Demand
2
0
Lecture 4
Domestic
Demand
D
1000
F
B
2000
3000
Wheat(million bushels/yr.)
4000
Slide 34
Consumer Surplus

Consumer Surplus
 The
difference between the maximum
amount a consumer is willing to pay for
a good and the amount actually paid.
Lecture 4
Slide 35
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
Lecture 4
1
2
3
4
5
6
Rock Concert Tickets
Slide 36
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  $19,500
Market Price
14
13
Demand Curve
Actual
Expenditure
0
Lecture 4
1
2
3
4
5
6
Rock Concert Tickets
Slide 37
Consumer Surplus

Combining consumer surplus with
the aggregate profits that producers
obtain we can evaluate:
1) Costs and benefits of different
market structures
2) Public policies that alter the
behavior of consumers and firms
Lecture 4
Slide 38
An Example:
The Value of Clean Air

Air is free in the sense that we don’t
pay to breathe it.

The Clean Air Act was amended in
1970.

Question: Were the benefits of
cleaning up the air worth the costs?
Lecture 4
Slide 39
The Value of Clean Air

People pay more to buy houses
where the air is clean.

Data for house prices among
neighborhoods of Boston and Los
Angeles were compared with the
various air pollutants.
Lecture 4
Slide 40
Valuing Cleaner Air
Value
($ per pphm
of reduction)
2000
A
1000
0
Lecture 4
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.
10
NOX (pphm)
Pollution Reduction
Slide 41
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 price.

Problem. Consumers may lack
information or interest, or be mislead
by the interviewer.
Lecture 4
Slide 42
Empirical Estimation of Demand

In direct marketing experiments,
actual sales offers are posed to
potential customers and the
responses of customers are
observed.
Lecture 4
Slide 43
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.
Lecture 4
Slide 44
Demand Data for Raspberries
Year Quantity (Q)
1988
1989
1990
1991
1992
1993
1994
1995
1996
Lecture 4
4
7
8
13
16
15
19
20
22
Price (P)
24
20
17
17
10
15
12
9
5
Income(I)
10
10
10
17
17
17
20
20
20
Slide 45
Estimating Demand
Price
25
D represents demand
if only P determines
demand and then from
the data: Q=28.2-1.00P
20
15
d1
10
d2
5
D
d3
0
Lecture 4
5
10
15
20
25 Quantity
Slide 46
Estimating Demand
Adjusting for changes in income
Price
25
d1, d2, d3 represent the demand for each
income level. Including income in the
demand equation: Q = a - bP + cI or
Q = 8.08 - .49P + .81I
20
15
d1
10
d2
5
D
d3
0
Lecture 4
5
10
15
20
25 Quantity
Slide 47
Empirical Estimation of Demand
Estimating Elasticities

Assuming: Price & income elasticity
are constant
 The
isoelastic demand =
log(Q)  a  b log( P)  c log( I )
 The
slope, -b = price elasticity of demand
 Constant,
Lecture 4
c = income elasticity
Slide 48
Empirical Estimation of Demand
Estimating Elasticities

Using the Raspberry data:
log(Q)  0.81  2.4 log( P)  1.46 log( I )
 Price
elasticity = -0.24 (Inelastic)
 Income
Lecture 4
elasticity = 1.46
Slide 49
Empirical Estimation of Demand
Estimating Complements and Substitutes
log(Q)  a  b log( P)  b2 log P2  c log( I )

Substitutes: b2 is positive

Complements: b2 is negative
Lecture 4
Slide 50
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.
Lecture 4
Slide 51
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 market demand curve is the
horizontal summation of the
individual demand curves for all
consumers.
Lecture 4
Slide 52