Chapter 4

INDIVIDUAL AND MARKET DEMAND Chapter 4 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline The Effects of Changes in the Price The Effects of Changes in Income The Income and Substitution Effects of a Price Change Consumer Responsiveness to Changes in Price Market Demand: Aggregating Individual Demand Curves Price Elasticity of Demand The Dependence of Market Demand on Income Application: Forecasting Economic Trends Cross-Price Elasticities of Demand

The Effect of Changes in Price Price-consumption curve (PCC): for a good X is the set of optimal bundles traced on an indifference map as the price of X varies (holding income and the price of Y constant).

Figure 4.1: The Price-Consumption Curve Y (R/wk) 1 200 1 000 800 600 400 360 300 200 (sq m/wk)

Figure 4.2: An Individual Consumer’s Demand Curve Price (R/sq m) 240 200 150 120 100 60 50 40 Shelter (sq m/wk)

The Effects of Changes in Income Income-consumption curve (ICC): for a good X is the set of optimal bundles traced on an indifference map as income varies (holding the prices of X and Y constant). Engel curve: curve that plots the relationship between the optimal quantity of X consumed and income.

The Effects of Changes in Income Normal good: one whose quantity demanded rises as income rises. Inferior good: one whose quantity demanded falls as income rises.

Figure 4.3: An Income-Consumption Curve The composite good (R/wk) 1 200 1 000 800 600 500 400 300 200 Shelter (sq m/wk)

Figure 4.4: An Individual Consumer’s Engel Curve Income (R/wk) 1 200 1 000 800 600 400 200 Shelter(sq m/wk)

Figure 4.5: The Engel Curve for Normal and Inferior Goods M (R/wk) M (R/wk) Maize porridge (kg/wk)

Income and Substitution Effects Substitution effect: that component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods. Income effect: that component of the total effect of a price change that results from the associated change in real purchasing power. Total effect: the sum of the substitution and income effects.

Figure 4.6: The Total Effect of a Price Increase Y (R/wk) 1 200 700 600 Shelter (sq m/wk)

Figure 4.7: The Substitution and Income Effects of a Price Change for a Normal Good Y (R/wk) 2400 1200 960 720 600 Shelter (sq m/wk)

Figure 4.8: Income and Substitution Effects for an Inferior Good Y (R/wk) 340 240 180 160 60 Maize porridge (kg/wk)

Giffen Goods Giffen good: one for which the quantity demanded rises as its price rises. The Giffen good is also an inferior good

Figure 4.9: The Demand Curve for a Giffen Good Price of potatoes (R/kg) Potatoes (R/wk)

Figure 4.10: Income and Substitution Effects for Perfect Complements

Figure 4.11: Income and Substitution Effects for Perfect Substitutes

Figure 4.12: Income and Substitution Effects of a Price Increase for Salt Y (R/mo) Y (R/mo) 0.5 0.5002 Salt (kg/mo) 0.5001 Salt (kg/mo) 1 500 3 000

Figure 4.13: Income and Substitution Effects for a Price-Sensitive Good Y (R/wk) Y (R/wk) 240 000 120 000 108 000 72 000 60 000 Shelter (sq m/wk)

Figure 4.14: A Price Increase for Car Washes Petrol (R/mo) P = 40W 384 320 240 160 4 6 8 12

Figure 4.15: James’ Demand for Car Washes Price (R/wash) 560 240 80

Market Demand Curves Market demand curve: the horizontal summation of the individual demand curves. Price elasticity of demand: the persentage change in the quantity of a good demanded that result from a 1 present change in its price.

Figure 4.16: Generating Market Demand from Individual Demands Price (R/sq m) Price (R/sq m) Price (R/sq m) 1 600 1 600 1 600 1 400 1 400 1 400 1 200 1 200 1 200 1 000 1 000 1 000 800 800 800 600 600 600 400 400 400 200 200 200 20 40 60 80 100 20 40 60 80 20 40 60 80100120 Quantity (sq m/wk) Quantity (sq m/wk) Quantity (sq m/wk)

Figure 4.17: The Market Demand Curve for Beach Chairs Price (R/chair) Price (R/chair) Price (R/chair) 300 300 300 Quantity (Chairs/wk) Quantity (Chairs/wk) Quantity (Chairs/wk)

Figure 4.18: Market Demand with Identical Consumers Price (R/unit)

Three Categories of Price Elasticity Inelastic → ε > -1 Unit elastic → ε = 1

Figure 4.19: Three Categories of Price Elasticity Unit elastic Unit elastic Elastic Inelastic Inelastic Elastic -3 -2 -1 1 2 (a) Normal calculated values (b) Absolute values

Figure 4.20: The Point-Slope Method Price (R/sq m) 1 600 1 400 PA = 1 200 €A = (PA /QA )(1/slope) = (1200/200)(-1/2) = -3 1 000 800 600 400 200 Quantity (sq m/wk) 400 600 800 1 000 2 000 200 = QA

Figure 4.21: Two Important Polar Cases

Figure 4.22: Elasticity is Unit-Free P (R/l) P (R/100g) 12 0,09375 9 0,0703175 150 150 R/day R/day

Elasticity and Total Revenue A price reduction will increase total revenue if and only if the absolute value of the price elasticity of demand is greater than 1. An increase in price will increase total revenue if and only if the absolute value of the price elasticity is less than 1.

Figure 4.23: The Effect on Total Expenditure of a Reduction in Price Price (R/sq m) 1 600 1 400 1 200 1 000 800 600 400 200 Quantity (sq m/wk) 200 400 600 800 1 000 1 400 1 200 1 600

Figure 4.24: Demand and Total Expenditure

Figure 4.25: The Demand for Bus Rides Price (R/ride) 10.00 7.50 5.00 2.50

Determinants of Price Elasticity of Demand Substitution possibilities: the substitution effect of a price change tends to be small for goods with no close substitutes. Budget share: the larger the share of total expenditures accounted for by the product, the more important will be the income effect of a price change. Direction of income effect: a normal good will have a higher price elasticity than an inferior good. Time: demand for a good will be more responsive to price in the long-run than in the short-run.

Figure 4.26: Effect of an energy tax with a rebate Expenditure on other goods (R) After energy tax Plus rebate F A After energy tax H C E U2 U1 Original budget line 900 1 200 D J J Electricity Consumption (units per year) 913.5

Quantities (millions of Figure 4.27: Price Elasticity Is Greater in the Long Run than in the Short Run Price (R/litre) PSR = 10.00 P LR = 8.50 7.50 Quantities (millions of litres/day)

Figure 4.28: The Engel Curve for Food of A and B Income (R/wk) 1 800 1 200 600 Food (kg/wk)

Figure 4.29: Market Demand Sometimes Depends on the Distribution of Income Price (R/kg) Price (R/kg) Price (R/kg) A’s food (kg/wk) B’s food (kg/wk) Food (kg/wk)

Figure 4.30: An Engel Curve at the Market Level Average Income (R/wk)

Figure 4.31: Engel Curves for Different Types of Goods Average Income (R/wk) Average Income (R/wk)

Figure 4.32: Positive Network Externality: Bandwagon Effect Demand D20 D60 D40 D100 D80 Q (1000/pm) P (R/unit) 40 60 80 100 20 48 200 Pure price effect Bandwagon effect

Figure 4.33: : Negative Network Externality: Snob Effect Demand D2 D6 D4 D8 Q (1000/pm) P (R/unit) 4 6 8 14 2 150 000 Pure price effect Snob effect 300 000 Net effect

Figure 4.34: A Constant Elasticity Demand Curve

Figure 4.35: The Segment-Ratio Method

Figure 4.36: Elasticity at Different Positions Along a Straight-Line Demand Curve

Figure 4.37: Intertemporal Consumption Bundles

Figure 4.38: The Intertemporal Budget Constraint 120 000 60 000 50 000 100 000

Figure 4.39: Intertemporal Budget Constraint with Income in Both Periods, and Borrowing or Lending at Rate r

Figure 4.40: An Intertemporal Indifference Map

Figure 4.41: The Optimal Intertemporal Allocation

Figure 4.42: Patience and Impatience

Figure 4.43: The Effect of a Rise in the Interest Rate