Chapter 4

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

Empirical Estimation of Demand

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 4

$1.00 12

$0.50 20

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 consumers 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 incomeThe income elasticity of demand is positiveThe 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 incomeThe income elasticity of demand is negativeThe 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

If two goods are independent, then a change in the price of one good has no effect on the quantity demanded of the other Ex: price of chicken and price of 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 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 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 regarding 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 relatively

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 relatively 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 US 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 the 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 represents 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 worthwhile

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 2,000people 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

Chapter 4 72©2005 Pearson Education, Inc.

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 73©2005 Pearson Education, Inc.

Empirical Estimation of Demand

Problem Consumers may lack information or interest,

or be misled by the interviewer

Chapter 4 74©2005 Pearson Education, Inc.

Empirical Estimation of Demand

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

Chapter 4 75©2005 Pearson Education, Inc.

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

Chapter 4 76©2005 Pearson Education, Inc.

Demand Data for Raspberries

Chapter 4 77©2005 Pearson Education, Inc.

Empirical Estimation of Demand

Assuming only price determines demand: Q = a - bP Q = 28.2 -1.00P

Chapter 4 78©2005 Pearson Education, Inc.

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 79©2005 Pearson Education, Inc.

Estimating Demand – Changes in Income

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 or Q = 8.08 - .49P + .81I

Chapter 4 80©2005 Pearson Education, Inc.

Empirical Estimation of Demand

Estimating Elasticities For the demand equation: Q = a - bP

Elasticity:

)/()/)(/( QPbQPPQEP

Chapter 4 81©2005 Pearson Education, Inc.

Empirical Estimation of Demand

Assuming: Price and income elasticity are constant The isoelastic demand =

)log()log()log( IcPbaQ

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

Chapter 4 82©2005 Pearson Education, Inc.

Empirical Estimation of Demand

Using the Raspberry data:

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

Price elasticity = -0.24 (Inelastic)Income elasticity = 1.46

Chapter 4 83©2005 Pearson Education, Inc.

Empirical Estimation of Demand

Substitutes: b2 is positive

Complements: b2 is negative

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

Complements and Substitutes

Chapter 4 84©2005 Pearson Education, Inc.

The Demand for Ready-to-Eat Cereal

Are Grape Nuts and Spoon Size Shredded Wheat good substitutes? Estimated demand for Grape Nuts (GN)

)log(14.0)log(62.0)log(085.2998.1)log( SWGNGN PIPQ

Price elasticity = -2.0Income elasticity = 0.62Cross elasticity = 0.14