Lecture 4Slide 1 Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Empirical Estimation of Demand.

Lecture 4 Slide 1

Topics to be Discussed

Individual Demand

Income and Substitution Effects

Market Demand

Consumer Surplus

Empirical Estimation of Demand

Lecture 4 Slide 2

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

Lecture 4 Slide 3

Price-Consumption Curve



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.

Lecture 4 Slide 4


Demand Curve

Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.


Priceof Food

H

E

G

$2.00

4 12 20

$1.00

$.50

Lecture 4 Slide 5

Effects of Income Changes


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

Lecture 4 Slide 6

Effects of Income Changes


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

Lecture 4 Slide 7

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

Lecture 4 Slide 8

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

Lecture 4 Slide 9

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...

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 $)

Lecture 4 Slide 11

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

Lecture 4 Slide 12

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


Lecture 4 Slide 13

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


Lecture 4 Slide 14


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.

Lecture 4 Slide 15


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.

Lecture 4 Slide 16


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.

Lecture 4 Slide 17


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.

Lecture 4 Slide 18


Income EffectEven with inferior goods, the income

effect is rarely large enough to outweigh the substitution effect.

Lecture 4 Slide 19

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.

Lecture 4 Slide 20

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

Lecture 4 Slide 21


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.

Lecture 4 Slide 22

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

Lecture 4 Slide 23

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)

Lecture 4 Slide 24

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

Lecture 4 Slide 25

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

Lecture 4 Slide 26

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.

Lecture 4 Slide 27

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)

Lecture 4 Slide 28

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)

Lecture 4 Slide 29

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

)/

Lecture 4 Slide 30

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

Lecture 4 Slide 31

The Aggregate Demand For Wheat

The demand for U.S. wheat is comprised of domestic demand and export demand.

An Example:

Lecture 4 Slide 32


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

Lecture 4 Slide 33


Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4).

Lecture 4 Slide 34

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


Wheat(million bushels/yr.)

Price ($/bushel)

0

2

4

6

8

10

12

14

16

18

20

1000 2000 3000 4000

Lecture 4 Slide 35

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 36

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

Lecture 4 Slide 37

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

Lecture 4 Slide 38

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 39

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:

Lecture 4 Slide 40

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 41

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)

Lecture 4 Slide 42


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 43

In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed.


Lecture 4 Slide 44

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.


Lecture 4 Slide 45

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

Lecture 4 Slide 46

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

Lecture 4 Slide 47

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

Lecture 4 Slide 48

Assuming: Price & income elasticity are constant

The isoelastic demand =

The slope, -b = price elasticity of demandConstant, c = income elasticity


Estimating ElasticitiesEstimating Elasticities

)log()log()log( IcPbaQ

Lecture 4 Slide 49

Using the Raspberry data:

Price elasticity = -0.24 (Inelastic)

Income elasticity = 1.46


Estimating ElasticitiesEstimating Elasticities

)log(46.1)log(4.281.0)log( IPQ

Lecture 4 Slide 50

Substitutes: b2 is positive

Complements: b2 is negative


Estimating Complements and SubstitutesEstimating Complements and Substitutes

)log(log)log()log( 22 IcPbPbaQ

Lecture 4 Slide 51

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 52

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 4Slide 1 Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Empirical Estimation of Demand.

Documents

inferior good slide

income consumption curve

income elasticity of

income group

d3d3 h slide

price change food units

month clothing units

inferior good hamburger