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Chapter 4 Individual and Market Demand

Topics to be Discussed

Individual Demand

Income and Substitution Effects


Market Demand Consumer Surplus

Chapter 4

Slide 2

Topics to be Discussed

Network Externalities

Empirical Estimation of Demand

Chapter 4

Slide 3

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.

Chapter 4

Slide 4

Effect of a Price Change


Clothing (units per month)

10

Assume: I = $20 PC = $2 PF = $2, $1, $.50


A
U1

6 5 4

D B U3

Three separate indifference curves are tangent to each budget line.

U2
Food (units per month)

4
Chapter 4

12

20

Slide 5

Effect of a Price Change


Clothing (units per month)
The price-consumption curve traces out the utility maximizing market basket for the various prices for food.
A
U1

6 5 4

Price-Consumption Curve
D B U3

U2

4
Chapter 4

12

20

Food (units per month)

Slide 6

Effect of a Price Change


Price of Food

$2.00

Individual Demand relates the quantity of a good that a consumer will buy to the price of that good.

$1.00
Demand Curve $.50 H
Food (units per month)

4
Chapter 4

12

20

Slide 7

Individual Demand
The Individual Demand Curve

Two Important Properties of Demand Curves 1) The level of utility that can be attained changes as we move along the curve.

Chapter 4

Slide 8

Individual Demand
The Individual Demand Curve

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 and clothing.

Chapter 4

Slide 9

Effect of a Price Change


Price of Food

When the price falls: Pf/Pc & MRS also fall


E

$2.00

E: Pf/Pc = 2/2 = 1 = MRS G: Pf/Pc = 1/2 = .5 = MRS H:Pf/Pc = .5/2 = .25 = MRS Demand Curve

$1.00

$.50

H
Food (units per month)

4
Chapter 4

12

20

Slide 10

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.

Chapter 4

Slide 11

Effects of Income Changes


Clothing (units per month) Assume: Pf = $1 Pc = $2 I = $10, $20, $30

7 5 3
A B U1 U2

Income-Consumption Curve D U3 An increase in income, with the prices fixed, causes consumers to alter their choice of market basket.

4
Chapter 4

10

16

Food (units per month)


Slide 12

Effects of Income Changes


Price of food
An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumers demand curve to the right.

$1.00

D3
D2 D1

4
Chapter 4

10

16

Food (units per month)


Slide 13

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

Slide 14

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

Slide 15

Individual Demand
Normal Good vs. Inferior Good

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.
Slide 16

Chapter 4

Individual Demand
Normal Good vs. Inferior Good

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.
Slide 17

Chapter 4

An Inferior Good
Steak15 (units per month)
C Income-Consumption Curve Both hamburger and steak behave as a normal good, between A and B...

10
U3

U2 A U1

but hamburger becomes an inferior good when the income consumption curve bends backward between B and C.

5
Chapter 4

10

20

Hamburger 30 (units per month)


Slide 18

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

Slide 19

Engel Curves
Income ($ per month) 30

20

Engel curves slope upward for normal goods.

10

0
Chapter 4

12

16

Food (units per month)


Slide 20

Engel Curves
Income ($ per month) 30

Inferior 20
Engel curves slope backward bending for inferior goods.

Normal 10

0
Chapter 4

12

16

Food (units per month)


Slide 21

Consumer Expenditures in the United States


Income Group (1997 $)
Expenditure ($) on: Less than 1,000$10,000 19,000 20,00029,000 30,000- 40,00039,000 49,000 50,000- 70,00069,000 and above

Entertainment

700

947 1725 2170 1697

1274 2253 2371 1918

1514 3243 2536 1820

2054 4454 2137 2052

2654 5793 1540 2214

4300 9898 1266 2642

Owned Dwellings 1116 Rented Dwellings1957 Health Care 1031

Food
Clothing

2656
859

3385
978

4109
1363

4888
1772

5429
1778

6220
2614

8279
3442

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.

e.g. movie tickets and video rentals


Slide 23

Chapter 4

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.

e.g. gasoline and motor oil


Slide 24

Chapter 4

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

Chapter 4

Slide 25

Individual Demand

Substitutes and 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!


Slide 26

Chapter 4

Income and Substitution Effects

A fall in the price of a good has two effects: Substitution & Income

Substitution 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 27

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.

Chapter 4

Slide 28

Income and Substitution Effects

Substitution Effect

The substitution effect is the change in an items 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.
Slide 29

Chapter 4

Income and Substitution Effects

Income Effect

The income effect is the change in an items consumption brought about by the increase in purchasing power, with the price of the item held constant.
When a persons income increases, the quantity demanded for the product may increase or decrease.

Chapter 4

Slide 30

Income and Substitution Effects

Income Effect

Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

Chapter 4

Slide 31

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. The income effect, EF2, ( from D to B) keeps relative prices constant but increases purchasing power.

C1

D C2
Substitution Effect

U2 U1
E S F2
Income Effect

O
Chapter 4

F1

Total Effect

Food (units per month)


Slide 32

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.

U2

Substitution Effect

U1
E S F2 T
Food (units per month)
Slide 33
Income Effect

F1
Total Effect

Chapter 4

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

Slide 34

Effect of a Gasoline Tax With a Rebate

Assume
Ped =

-0.5
= $9,000

Income

Price

of gasoline = $1

Chapter 4

Slide 35

Effect of a Gasoline Tax With a Rebate


Expenditures On Other Goods ($)

F A

After Gasoline Tax Plus Rebate

$.50 Excise Tax Gasoline = 900 gallons


$450 REBATE New budget line Consumer is worse off

H
After Gasoline Tax

Gasoline = 1200 gallons Other expenditures = $7800

U1

U2 U3

Original Budget Line


Gasoline Consumption (gallons/year)

900 913.5 1200

Chapter 4

Slide 36

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.

Chapter 4

Slide 37

Determining the Market Demand Curve


Price Individual A Individual B Individual C Market ($) (units) (units) (units) (units)

1 2 3 4 5
Chapter 4

6 4 2 0 0

10 8 6 4 2

16 13 10 7 4

32 25 18 11 6
Slide 38

Summing to Obtain a Market Demand Curve


Price 5 4 3 Market Demand 2
The market demand curve is obtained by summing the consumers demand curves

DA
5

DB
10 15

DC
20 25 30 Quantity

0
Chapter 4

Slide 39

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 40

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.

Q/Q Q / P EP P/P Q/P


Chapter 4 Slide 41

Price Elasticity and Consumer Expenditure


Demand If Price Increases, Expenditures: Increase If Price Decreases, Expenditures: Decrease Are unchanged Increase

Inelastic (Ep <1)

Unit Elastic (Ep = 1) Are unchanged Elastic (Ep >1) Decrease

Chapter 4

Slide 42

Market Demand

Point Elasticity of Demand

For 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 43

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)
Chapter 4 Slide 44

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.

Chapter 4

Slide 45

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%

Chapter 4

Slide 46

Market Demand
Point Elasticity of Demand (An Example)

Elasticity equals: -33.33/.25 = -1.33 or -.50/.20 = -2.54 Which one is correct?

Chapter 4

Slide 47

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 averag price e Q the averag quantity e


Chapter 4 Slide 48

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

Chapter 4

Slide 49

An Example:
The Aggregate Demand For Wheat

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

Chapter 4

Slide 50

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 51

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 52

The Aggregate Demand For Wheat


Price
($/bushel)

20 18 16 14
A

Total world demand is the horizontal sum of the domestic demand AB and export demand CD.

12
10
C

8 6 4 2
0
Chapter 4
Export Demand

Total Demand
Domestic Demand

Wheat(million bushels/yr.)

1000

2000

3000

4000
Slide 53

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 54

Consumer Surplus
Price
($ per ticket)

20 19 18 17 16 15 14 13

The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually.

Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 Market Price

0
Chapter 4

Rock Concert Tickets


Slide 55

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 56

Consumer Surplus
Price
($ per ticket)

20 19 18 17 16 15 14 13
Actual Expenditure Consumer Surplus

Consumer Surplus for the Market Demand

1/2x(20 14)x6,500 $19,500


Market Price

Demand Curve

0
Chapter 4

Rock Concert Tickets


Slide 57

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 58

An Example:

The Value of Clean Air

Air is free in the sense that we dont pay to breathe it.

The Clean Air Act was amended in 1970. Question: Were the benefits of cleaning up the air worth the costs?
Slide 59

Chapter 4

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 60

Valuing Cleaner Air


Value ($ per pphm of reduction)

2000

1000

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.

0
Chapter 4

10

NOX (pphm) Pollution Reduction Slide 61

Network Externalities

Up to this point we have assumed that peoples demands for a good are independent of one another. If fact, a persons demand may be affected by the number of other people who have purchased the good.

Chapter 4

Slide 62

Network Externalities

If this is the case, a network externality exists. Network externalities can be positive or negative.

Chapter 4

Slide 63

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 64

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).

Chapter 4

Slide 65

Positive Network Externality: Bandwagon Effect


Price
($ per unit)

D20

D40 D60 D80 D100

When consumers believe more people have purchased the product, the demand curve shifts further to the the right .

Quantity

20
Chapter 4

40

60

80

100

(thousands per month)

Slide 66

Positive Network Externality: Bandwagon Effect


Price
($ per unit)

D20

D40 D60 D80 D100

The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic.

Demand

Quantity

20
Chapter 4

40

60

80

100

(thousands per month)

Slide 67

Positive Network Externality: Bandwagon Effect


Price
($ per unit)

D20

D40 D60 D80 D100

$30

Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48,000

$20
Pure Price Effect

Demand

20
Chapter 4

40

48 60

80

100

Quantity
(thousands per month)

Slide 68

Positive Network Externality: Bandwagon Effect


Price
($ per unit)

D20

D40 D60 D80 D100

$30

But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further.

$20
Pure Price Effect

Demand
Bandwagon Effect 20 40 48 60 80
100

Quantity
(thousands per month)

Chapter 4

Slide 69

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.
Slide 70

Chapter 4

Negative Network Externality: Snob Effect


Price
($ per unit)

Demand

$30,000

Originally demand is D2, when consumers think 2000 people have bought a good.

However, if consumers think 4,000 people have bought the good, demand shifts from D2 to D6 and its snob value has been reduced.

$15,000

D2
D4
D8 2
Chapter 4

D6 Quantity 14
per month) (thousands

Pure Price Effect

Slide 71

Negative Network Externality: Snob Effect


Price
($ per unit)

Demand

$30,000

The demand is less elastic and as a snob good its value is greatly reduced if more people own it. Sales decrease as a result. Examples: Rolex watches and long lines at the ski lift.

Net Effect $15,000

Snob Effect

D2
D4
D8 2
Chapter 4

D6 Quantity 14
per month) (thousands

Pure Price Effect

Slide 72

Network Externalities and the Demands for Computers and Fax Machines

Examples of Positive Feedback Externalities


Mainframe

computers: 1954 - 1965

Microsoft

Windows PC operating
and e-mail

system
Fax-machines

Chapter 4

Slide 73

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 74

Empirical Estimation of Demand

Problem
Consumers

may lack information or interest, or be mislead by the interviewer.

Chapter 4

Slide 75

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

Slide 76

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.


Slide 77

Chapter 4

Demand Data for Raspberries


Year Quantity (Q) Price (P) Income(I)

1988 1989 1990 1991 1992 1993 1994 1995 1996


Chapter 4

4 7 8 13 16 15 19 20 22

24 20 17 17 10 15 12 9 5

10 10 10 17 17 17 20 20 20
Slide 78

Empirical Estimation of Demand

Assuming only price determines demand:


Q

= a - bP

= 28.2 -1.00P

Chapter 4

Slide 79

Estimating Demand
Price

25 20 15 d1 10 5 0
Chapter 4

D represents demand if only P determines demand and then from the data: Q=28.2-1.00P

d2
d3 5 10 15 20

25 Quantity
Slide 80

Estimating Demand
Price

Adjusting for changes in income


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

25 20 15 d1 10 5 0
Chapter 4

d2
d3 5 10 15 20

25 Quantity
Slide 81

Empirical Estimation of Demand


Estimating Elasticities

For the demand equation: Q = a - bP

Elasticity: EP (Q / P)( P / Q) b( P / Q)

Chapter 4

Slide 82

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 c = income elasticity


Slide 83

Constant,
Chapter 4

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

elasticity = 1.46

Chapter 4

Slide 84

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

Chapter 4

Slide 85

The Demand for Ready-to-Eat Cereal

What Do You Think?


Are

Grape Nuts & Spoon Size Shredded Wheat good substitutes?

Chapter 4

Slide 86

The Demand for Ready-to-Eat Cereal

Answer
Estimated

demand for Grape Nuts (GN)

) WSP (gol 410. ) I (gol 26.0 ) NGP (gol 580.2 a 899.1 ) NGQ(gol

Price elasticity = -2.0


Income elasticity = 0.62

Cross elasticity = 0.14


Slide 87

Chapter 4

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.
Slide 88

Chapter 4

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 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. The effect of a price change on the quantity demanded can be broken into a substitution effect and an income effect.

Chapter 4

Slide 90

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.
Slide 91

Chapter 4

Summary

There is a network externality when one persons demand is affected directly by the purchasing decisions of other consumers. A number of methods can be used to obtain information about consumer demand.

Chapter 4

Slide 92

End of Chapter 4 Individual and Market Demand