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Chapter 4
Individual and Market Demand
Chapter 4 2©2005 Pearson Education, Inc.
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Chapter 4 3©2005 Pearson Education, Inc.
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.
For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves
Chapter 4 4©2005 Pearson Education, Inc.
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
Chapter 4 5©2005 Pearson Education, Inc.
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
Chapter 4 6©2005 Pearson Education, Inc.
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:
Demand Schedule
P Q
$2.00 20
$1.00 12
$0.50 4
Chapter 4 7©2005 Pearson Education, Inc.
Effect of a Price Change
Demand Curve
Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50
Chapter 4 8©2005 Pearson Education, Inc.
Demand Curves – Important Properties
The level of utility that can be attained changes as we move along the curve.
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 9©2005 Pearson Education, Inc.
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
Chapter 4 10©2005 Pearson Education, Inc.
Individual Demand
Income Changes Using the figures developed in the previous
chapter, 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.
Chapter 4 11©2005 Pearson Education, Inc.
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
B
U2
D7
16
U3
Assume: Pf = $1, Pc = $2 I = $10, $20, $30
Chapter 4 12©2005 Pearson Education, Inc.
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 13©2005 Pearson Education, Inc.
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 14©2005 Pearson Education, Inc.
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
B
U2
D7
16
U3
Income Consumption Curve
Chapter 4 15©2005 Pearson Education, Inc.
Effects of Income Changes
Food (units per month)
Priceof
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.
$1.00
4
D1
E
10
D2
G
16
D3
H
Chapter 4 16©2005 Pearson Education, Inc.
Individual Demand
Income Changes When the income-consumption curve has a
positive slope:The quantity demanded increases with income.The income elasticity of demand is positive.The good is a normal good.
Chapter 4 17©2005 Pearson Education, Inc.
Individual Demand
Income Changes When the income-consumption curve has a
negative slope:The quantity demanded decreases with income.The income elasticity of demand is negative.The good is an inferior good.
Chapter 4 18©2005 Pearson Education, Inc.
An Inferior Good
Hamburger (units per month)
Steak(units per
month)
30
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes an inferior
good when the incomeconsumption curvebends backward between B and C.
105
AU1
5
20
10
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
Chapter 4 19©2005 Pearson Education, Inc.
Individual Demand
Engel Curves Engel curves relate the quantity of good
consumed to income. If the good is a normal good, the Engel curve
is upward sloping. If the good is an inferior good, the Engel
curve is downward sloping.
Chapter 4 20©2005 Pearson Education, Inc.
Engel Curves
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Engel curves slopeupward for
normal goods.
Chapter 4 21©2005 Pearson Education, Inc.
Engel Curves
Engel curves arebackward bending for inferior goods.
Inferior
Normal
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Chapter 4 22©2005 Pearson Education, Inc.
Annual US Household Consumer Expenditures
Chapter 4 23©2005 Pearson Education, Inc.
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 other. Ex: movie tickets and video rentals
Chapter 4 24©2005 Pearson Education, Inc.
Substitutes & Complements
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. Ex: gasoline and motor oil
Chapter 4 25©2005 Pearson Education, Inc.
Substitutes & Complements
Two goods are independent then a change in the price of one good has no effect on the quantity demanded of the other Ex: chicken and airplane tickets
Chapter 4 26©2005 Pearson Education, Inc.
Substitutes & Complements
If the price consumption curve is downward-sloping, the two goods are considered substitutes.
If the price consumption curve is upward-sloping, the two goods are considered complements.
They could be both.
Chapter 4 27©2005 Pearson Education, Inc.
Income and Substitution Effects
A change in the price of a good has two effects: Substitution Effect Income Effect
Chapter 4 28©2005 Pearson Education, Inc.
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.
Chapter 4 29©2005 Pearson Education, Inc.
Income and Substitution Effects
Income Effect Consumers experience an increase in real
purchasing power when the price of one good falls.
Chapter 4 30©2005 Pearson Education, Inc.
Income and Substitution Effects
Substitution Effect The substitution effect is the change in a
good’s consumption associated with a change in the price of the good, 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.
Chapter 4 31©2005 Pearson Education, Inc.
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 32©2005 Pearson Education, Inc.
Income and Substitution Effects
Income Effect Even with inferior goods, the income effect is
rarely large enough to outweigh the substitution effect.
Chapter 4 33©2005 Pearson Education, Inc.
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.
Chapter 4 34©2005 Pearson Education, Inc.
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
Chapter 4 35©2005 Pearson Education, Inc.
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.
Chapter 4 36©2005 Pearson Education, Inc.
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
Chapter 4 37©2005 Pearson Education, Inc.
Determining the Market Demand Curve
Price A B CMarket
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
Chapter 4 38©2005 Pearson Education, Inc.
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
Chapter 4 39©2005 Pearson Education, Inc.
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.
Chapter 4 40©2005 Pearson Education, Inc.
Market Demand
Aggregation is important to be able to discuss demand for different groups Households with children Consumers aged 20 – 30, etc.
Chapter 4 41©2005 Pearson Education, Inc.
Market Demand
Price Elasticity of Demand Measures the percentage change in the
quantity demanded resulting from a percent change in price.
Q
P
P
Q
P/P
Q/Q
P%
Q% EP
Chapter 4 42©2005 Pearson Education, Inc.
Price Elasticity of Demand
Inelastic Demand Ep is less than 1 in absolute value Quantity demanded is relative unresponsive
to a change in price %Q < %P Total expenditure (P*Q) increases when
price increases
Chapter 4 43©2005 Pearson Education, Inc.
Price Elasticity of Demand
Elastic Demand Ep is greater than than 1 in absolute value Quantity demanded is relative responsive to
a change in price %Q > %P Total expenditure (P*Q) decreases when
price increases
Chapter 4 44©2005 Pearson Education, Inc.
Price Elasticity andConsumer Expenditure
Chapter 4 45©2005 Pearson Education, Inc.
Price Elasticity of Demand
Isoelastic Demand When price elasticity of demand is constant
along the entire demand curve Demand curve is bowed inward (not linear)
Chapter 4 46©2005 Pearson Education, Inc.
The Aggregate Demand For Wheat
The demand for U.S. wheat is comprised of two components Domestic demand Export demand
Total demand for wheat can be obtained by aggregating these two demands
Chapter 4 47©2005 Pearson Education, Inc.
The Aggregate Demand For Wheat
The domestic demand for wheat is given by the equation: QDD = 1465 - 88P
The export demand for wheat is given by the equation: QDE = 1344 - 138P
Chapter 4 48©2005 Pearson Education, Inc.
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
Chapter 4 49©2005 Pearson Education, Inc.
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
Chapter 4 50©2005 Pearson Education, Inc.
Consumer Surplus
Consumers buy goods because it makes them better off
Consumer Surplus measures how much better off they are
Chapter 4 51©2005 Pearson Education, Inc.
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
Chapter 4 52©2005 Pearson Education, Inc.
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 $6 worth of surplus Can measure this for each ticket Total surplus is addition of surplus for each
ticket purchased
Chapter 4 53©2005 Pearson Education, Inc.
The consumer surplusof purchasing 6 concerttickets is the sum of the
surplus derived from each one individually.
Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21
Consumer Surplus - Example
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Will not buy more than 7 because surplus is negative
Chapter 4 54©2005 Pearson Education, Inc.
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
Chapter 4 55©2005 Pearson Education, Inc.
Demand Curve
ConsumerSurplus
Consumer Surplusfor the Market Demand
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
ActualExpenditure
14
15
16
17
18
19
20
Market Price
CS = ½ ($20 - $14)*(1600) = $19,500
Chapter 4 56©2005 Pearson Education, Inc.
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
Chapter 4 57©2005 Pearson Education, Inc.
Applying Consumer Surplus – 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?
Chapter 4 58©2005 Pearson Education, Inc.
The Value of Clean Air
Empirical data determined estimates for the demand for clean air
No 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.
Chapter 4 59©2005 Pearson Education, Inc.
The Value of Cleaner Air
Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve
Chapter 4 60©2005 Pearson Education, Inc.
The shaded area gives theconsumer surplus generated
when air pollution is reduced by 5 parts per 100million of nitrous oxide at
a cost of $1000 per part reduced.
Valuing Cleaner Air
2000
100
1000
5
A
NOX (pphm)Pollution Reduction
Value
Chapter 4 61©2005 Pearson Education, Inc.
Value of Cleaner Air
A full cost-benefit analysis would include total benefit of cleanup
Total benefits would be compared to total costs to determine if the clean up was worth while
Chapter 4 62©2005 Pearson Education, Inc.
Network Externalities
Up to this point we have assumed that people’s demands for a good are independent of one another.
For some goods, one person’s demand also depends on the demands of other people
Chapter 4 63©2005 Pearson Education, Inc.
Network Externalities
If this is the case, a network externality exists.
Network externalities can be positive or negative.
Chapter 4 64©2005 Pearson Education, Inc.
Network Externalities
A positive network externality exists if the quantity of a good demanded by a consumer increases in response to an increase in purchases by other consumers.
Negative network externalities are just the opposite.
Chapter 4 65©2005 Pearson Education, Inc.
Network Externalities
The Bandwagon Effect This is the desire to be in style, to have a
good because almost everyone else has it, or to indulge in a fad.
This is the major objective of marketing and advertising campaigns (e.g. toys, clothing).
Positive network externality in which a consumer wishes to possess a good in part because others do
Chapter 4 66©2005 Pearson Education, Inc.
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ 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
Chapter 4 67©2005 Pearson Education, Inc.
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20
The market demandcurve is found by joiningthe points on the individual demand curves. It is relativelymore elastic.
40
D40
60
D60
80
D80
100
D100
Demand
Chapter 4 68©2005 Pearson Education, Inc.
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
$20
Pure PriceEffect
BandwagonEffect
Chapter 4 69©2005 Pearson Education, Inc.
Network Externalities
The Snob Effect If the network externality is negative, a snob
effect exists.
The snob effect refers to the desire to own exclusive or unique goods.
The quantity demanded of a “snob” good is higher the fewer the people who own it.
Chapter 4 70©2005 Pearson Education, Inc.
Network Externality: Snob Effect
Quantity (thousandsper month)
Price($ per
unit)
2
Demand
D2
$30,000
$15,000
14
Originally demand is D2,when consumers think 2000
people have bought a good.
4 6 8
D4
D6D8
However, if consumers think 4,000 people have bought the good,
demand shifts from D2 to D6 and its snob value has been reduced.
Pure Price Effect
Chapter 4 71©2005 Pearson Education, Inc.
Network Externality: Snob Effect
Quantity (thousandsper month)
Price($ 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 long lines at the ski lift.
Net Effect Snob Effect