Chapter 4 Individual and Market Demand
Chapter 4 Individual and Market Demand Individual and Market Demand.
Mar 26, 2015
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Chapter 4Individual and
Market Demand
Individual and
Market Demand
Chapter 4 Slide 2
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Chapter 4 Slide 3
Topics to be Discussed
Network Externalities
Empirical Estimation of Demand
Chapter 4 Slide 4
Individual Demand
Price ChangesUsing the figures developed in the
previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.
Chapter 4 Slide 5
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
4
5
6
U2
U3
A
BDU1
4 12 20
Three separateindifference curves
are tangent toeach budget line.
Assume: •I = $20•PC = $2•PF = $2, $1, $.50
10
Chapter 4 Slide 6
Price-Consumption Curve
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
4
5
6
U2
U3
A
BDU1
4 12 20
The price-consumptioncurve traces out theutility maximizing
market basket for thevarious prices for food.
Chapter 4 Slide 7
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 Slide 8
Individual Demand
Two Important Properties of Demand Curves
1) The level of utility that can be attained changes as we move
along the curve.
The Individual Demand CurveThe Individual Demand Curve
Chapter 4 Slide 9
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 andclothing.
The Individual Demand CurveThe Individual Demand Curve
Chapter 4 Slide 10
Effect of a Price Change
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50
Demand 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 Slide 11
Individual Demand
Income ChangesUsing the figures developed in the
previous chapter, the impact of a change in the income can be illustrated using indifference curves.
Chapter 4 Slide 12
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.
Income-Consumption Curve
3
4
A U1
5
10
B
U2
D7
16
U3
Assume: Pf = $1 Pc = $2
I = $10, $20, $30
Chapter 4 Slide 13
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’sdemand curve to the right.
$1.00
4
D1
E
10
D2
G
16
D3
H
Chapter 4 Slide 14
Individual Demand
Income ChangesThe income-consumption curve traces
out the utility-maximizing combinations of food and clothing associated with every income level.
Chapter 4 Slide 15
Individual Demand
Income ChangesAn increase in income shifts the budget
line to the right, increasing consumption along the income-consumption curve.
Simultaneously, the increase in income shifts the demand curve to the right.
Chapter 4 Slide 16
Individual Demand
Income ChangesWhen the income-consumption curve
has a positive slope:The quantity demanded increases
with income.The income elasticity of demand is
positive.The good is a normal good.
Normal Good vs. Inferior GoodNormal Good vs. Inferior Good
Chapter 4 Slide 17
Individual Demand
Income ChangesWhen the income-consumption curve
has a negative slope:The quantity demanded decreases
with income.The income elasticity of demand is
negative.The good is an inferior good.
Normal Good vs. Inferior GoodNormal Good vs. Inferior Good
Chapter 4 Slide 18
An Inferior Good
Hamburger (units per month)
Steak(units per
month)
15
30
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes an inferior
good when the incomeconsumption curvebends backward between B and C.
105 20
5
10
AU1
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
Chapter 4 Slide 19
Individual Demand
Engel CurvesEngel curves relate the quantity of good
consumed to income.
If the good is a normal good, the Engel curve is upward sloping.
If the good is an inferior good, the Engel curve is downward sloping.
Chapter 4 Slide 20
Engel Curves
Food (unitsper month)
30
4 8 12
10
Income($ per
month)
20
160
Engel curves slopeupward for
normal goods.
Chapter 4 Slide 21
Engel Curves
Engel curves slopebackward bending for inferior goods.
Inferior
Normal
Food (unitsper month)
30
4 8 12
10
Income($ per
month)
20
160
Consumer Expendituresin the United States
Entertainment 700 947 1274 1514 2054 2654 4300
Owned Dwellings1116 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
Clothing 859 978 1363 1772 1778 2614 3442
Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000-($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above
Income Group (1997 $)
Chapter 4 Slide 23
Individual Demand
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. movie tickets and video rentals
Substitutes and ComplementsSubstitutes and Complements
Chapter 4 Slide 24
Individual Demand
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. gasoline and motor oil
Substitutes and ComplementsSubstitutes and Complements
Chapter 4 Slide 25
Individual Demand
3) Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other
Substitutes and ComplementsSubstitutes and Complements
Chapter 4 Slide 26
Individual Demand
Substitutes and ComplementsIf 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 Slide 27
Income and Substitution Effects
A fall in the price of a good has two effects: Substitution & IncomeSubstitution Effect
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.
Chapter 4 Slide 28
Income and Substitution Effects
A fall in the price of a good has two effects: Substitution & IncomeIncome Effect
Consumers experience an increase in real purchasing power when the price of one good falls.
Chapter 4 Slide 29
Income and Substitution Effects
Substitution EffectThe 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 30
Income and Substitution Effects
Income EffectThe 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 31
Income and Substitution Effects
Income EffectEven with inferior goods, the income
effect is rarely large enough to outweigh the substitution effect.
Chapter 4 Slide 32
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 Slide 33
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 Slide 34
Income and Substitution Effects
A Special Case--The Giffen GoodThe 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 Slide 35
Effect of a Gasoline Tax With a Rebate
Assume
Ped = -0.5
Income = $9,000
Price of gasoline = $1
Chapter 4 Slide 36
Effect of a Gasoline Tax With a Rebate
Gasoline Consumption (gallons/year)
ExpendituresOn Other
Goods ($)
A
C •Gasoline = 1200 gallons•Other expenditures = $7800
U2
1200
Original BudgetLine
BD
U1
900
AfterGasoline
Tax
E
•$.50 Excise Tax•Gasoline = 900 gallons
J
F
H
913.5
After Gasoline TaxPlus Rebate
U3
•$450 REBATE•New budget line•Consumer is worse off
Chapter 4 Slide 37
Market Demand
Market Demand Curves
A curve that relates the quantity of a good that all consumers in a market buy to the price of that good.
From Individual to Market DemandFrom Individual to Market Demand
Chapter 4 Slide 38
Determining the Market Demand Curve
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
Price Individual A Individual B Individual C Market($) (units) (units) (units) (units)
Chapter 4 Slide 39
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 Slide 40
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 41
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.
PQ
PQ
P/P
Q/Q EP
/
/
Chapter 4 Slide 42
Price Elasticity andConsumer Expenditure
Demand If Price Increases, If Price Decreases,
Expenditures: Expenditures:Inelastic (Ep <1) Increase Decrease
Unit Elastic (Ep = 1) Are unchanged Are unchanged
Elastic (Ep >1) Decrease Increase
Chapter 4 Slide 43
Market Demand
Point Elasticity of DemandFor large price changes (e.g. 20%), the
value of elasticity will depend upon where the price and quantity lie on the demand curve.
Chapter 4 Slide 44
Market Demand
Point Elasticity of DemandPoint elasticity measures elasticity at a
point on the demand curve.
Its formula is:
ope)(P/Q)(1/sl E P
Chapter 4 Slide 45
Market Demand
Problems Using Point ElasticityWe 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 46
Market Demand
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%
Point Elasticity of Demand (An Example)Point Elasticity of Demand (An Example)
Chapter 4 Slide 47
Market Demand
Elasticity equals:
-33.33/.25 = -1.33 or -.50/.20 = -2.54
Which one is correct?
Point Elasticity of Demand (An Example)Point Elasticity of Demand (An Example)
Chapter 4 Slide 48
Market Demand
Arc Elasticity of DemandArc elasticity calculates elasticity over a
range of prices
Its formula is:
e quantitythe averagQ
e pricethe averagP
QPP)(Q/( E P
)/
Chapter 4 Slide 49
Market Demand
Arc Elasticity of Demand (An Example)
8.1)5/9)($2$/2(52/10&92/184,6,10,8
)/2121
pEQP
QQPPQPP)(Q/( E P
Chapter 4 Slide 50
The Aggregate Demand For Wheat
The demand for U.S. wheat is comprised of domestic demand and export demand.
An Example:
Chapter 4 Slide 51
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:
QDE = 1544 - 176P
Chapter 4 Slide 52
The Aggregate Demand For Wheat
Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4).
Chapter 4 Slide 53
C
D
ExportDemand
A
B
DomesticDemand
Total world demand is the horizontal sum of the domestic demand AB and
export demand CD.
F
Total Demand
E
The Aggregate Demand For Wheat
Wheat(million bushels/yr.)
Price ($/bushel)
0
2
4
6
8
10
12
14
16
18
20
1000 2000 3000 4000
Chapter 4 Slide 54
Consumer Surplus
Consumer Surplus
The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid.
Chapter 4 Slide 55
The consumer surplusof purchasing 6 concerttickets is the sum of the
surplus derived from each one individually.
Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Chapter 4 Slide 56
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 57
Demand Curve
ConsumerSurplus
ActualExpenditure
$19,50014)x6,5001/2x(20
Consumer Surplusfor the Market Demand
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Chapter 4 Slide 58
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 Slide 59
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?
An Example:
Chapter 4 Slide 60
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.
Chapter 4 Slide 61
The shaded area gives theconsumer surplus generated
when air pollution is reduced by 5 parts per 100million of nitrous oxide at
a cost of $1000 per part reduced.
Valuing Cleaner Air
2000
100
1000
5
A
NOX (pphm)Pollution Reduction
Value($ per pphm
of reduction)
Chapter 4 Slide 62
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 63
Network Externalities
If this is the case, a network externality exists.
Network externalities can be positive or negative.
Chapter 4 Slide 64
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 65
Network Externalities
The Bandwagon EffectThis 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 66
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20 40
When consumers believe more people have purchased theproduct, the demand curve shifts further to the the right .
D40
60
D60
80
D80
100
D100
Chapter 4 Slide 67
Demand
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20 40 60 80 100
D40 D60 D80 D100 The market demandcurve is found by joining
the points on the individual demand curves. It is relatively
more elastic.
Chapter 4 Slide 68
Demand
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20 40 60 80 100
D40 D60 D80 D100
Pure PriceEffect
48
Suppose the price fallsfrom $30 to $20. If there
were no bandwagon effect,quantity demanded would
only increase to 48,000
$20
$30
Chapter 4 Slide 69
Demand
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20 40 60 80 100
D40 D60 D80 D100
Pure PriceEffect
$20
48
BandwagonEffect
But as more people buythe good, it becomes stylish to own it and
the quantity demandedincreases further.$30
Chapter 4 Slide 70
Network Externalities
The Snob EffectIf the network externality is negative, a
snob effect exists.
The snob effect refers to the desire to own exclusive or unique goods.
The quantity demanded of a “snob” good is higher the fewer the people who own it.
Chapter 4 Slide 71
Negative NetworkExternality: Snob Effect
Quantity (thousandsper month)
Price($ per
unit) Demand
2
D2
$30,000
$15,000
14
Pure Price Effect
Originally demand is D2,when consumers think 2000
people have bought a good.
4 6 8
D4
D6D8
However, if consumers think 4,000 people have bought the good,
demand shifts from D2 to D6 and its snob value has been reduced.
Chapter 4 Slide 72
Negative NetworkExternality: Snob Effect
Quantity (thousandsper month)2 4 6 8
The demand is less elastic and as a snob good its value is greatly
reduced if more people ownit. Sales decrease as a result.
Examples: Rolex watches and long lines at the ski lift.
Price($ per
unit)
D2
$30,000
$15,000
14
D4
D6D8
Demand
Pure Price Effect
Snob EffectNet Effect
Chapter 4 Slide 73
Network Externalities and the Demands for Computers and Fax Machines
Examples of Positive Feedback Externalities
Mainframe computers: 1954 - 1965
Microsoft Windows PC operating system
Fax-machines and e-mail
Chapter 4 Slide 74
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.
Chapter 4 Slide 75
Empirical Estimation of Demand
Problem
Consumers may lack information or interest, or be mislead by the interviewer.
Chapter 4 Slide 76
In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed.
Empirical Estimation of Demand
Chapter 4 Slide 77
The Statistical Approach to Demand EstimationProperly 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.
Empirical Estimation of Demand
Chapter 4 Slide 78
Year Quantity (Q) Price (P) Income(I)
Demand Data for Raspberries
1988 4 24 10
1989 7 20 10
1990 8 17 10
1991 13 17 17
1992 16 10 17
1993 15 15 17
1994 19 12 20
1995 20 9 20
1996 22 5 20
Chapter 4 Slide 79
Assuming only price determines demand:
Q = a - bP
Q = 28.2 -1.00P
Empirical Estimation of Demand
Chapter 4 Slide 80
Estimating Demand
Quantity
Price
0 5 10 15 20 25
15
10
5
25
20
d1
d2
d3
D
D represents demandif only P determinesdemand and then from the data: Q=28.2-1.00P
Chapter 4 Slide 81
Estimating Demand
Quantity
Price
0 5 10 15 20 25
15
10
5
25
20
D
d1
d2
d3
d1, d2, d3 represent the demand for each income level. Including income in the demand equation: Q = a - bP + cI orQ = 8.08 - .49P + .81I
Adjusting for changes in income
Chapter 4 Slide 82
For the demand equation: Q = a - bP
Elasticity:
Empirical Estimation of Demand
Estimating ElasticitiesEstimating Elasticities
)/()/)(/( QPbQPPQEP
Chapter 4 Slide 83
Assuming: Price & income elasticity are constant
The isoelastic demand =
The slope, -b = price elasticity of demandConstant, c = income elasticity
Empirical Estimation of Demand
Estimating ElasticitiesEstimating Elasticities
)log()log()log( IcPbaQ
Chapter 4 Slide 84
Using the Raspberry data:
Price elasticity = -0.24 (Inelastic)
Income elasticity = 1.46
Empirical Estimation of Demand
Estimating ElasticitiesEstimating Elasticities
)log(46.1)log(4.281.0)log( IPQ
Chapter 4 Slide 85
Substitutes: b2 is positive
Complements: b2 is negative
Empirical Estimation of Demand
Estimating Complements and SubstitutesEstimating Complements and Substitutes
)log(log)log()log( 22 IcPbPbaQ
Chapter 4 Slide 86
What Do You Think?
Are Grape Nuts & Spoon Size Shredded Wheat good substitutes?
The Demand for Ready-to-Eat Cereal
Chapter 4 Slide 87
Answer
Estimated demand for Grape Nuts (GN)
Price elasticity = -2.0
Income elasticity = 0.62
Cross elasticity = 0.14
The Demand for Ready-to-Eat Cereal
) log( 014 . ) log( 62 . 0 ) log( 085 . 2 998 . 1 ) log(SW GN GNP I P a Q
Chapter 4 Slide 88
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 89
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 90
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 91
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 92
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.
End of Chapter 4
Individual and
Market Demand
Individual and
Market Demand
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