Individual and Market Demand Chapter 4 Individual and Market Demand

Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Network Externalities Empirical Estimation of Demand Chapter 4 2

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

Effect of a Price Change Food (units per month) Clothing Assume: I = $20 PC = $2 PF = $2, $1, $0.50 6 A U1 4 10 4 U2 B 12 20 5 U3 D Each price leads to different amounts of food purchased Chapter 4 4

Effect of a Price Change 4 U2 B 12 20 5 U3 D Food (units per month) Clothing 6 A U1 10 The Price-Consumption Curve traces out the utility maximizing market basket for each price of food Chapter 4 4

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

Effect of a Price Change Food (units per month) Price of Food H E G $2.00 4 12 20 $1.00 $.50 Individual Demand relates the quantity of a good that a consumer will buy to the price of that good. Demand Curve Chapter 4 4

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 4

Effect of a Price Change Food (units per month) Price of Food When the price falls, Pf /Pc & MRS also fall 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 Chapter 4 4

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 4

Effects of Income Changes Food (units per month) Clothing (units per month) D 7 16 U3 Assume: Pf = $1, Pc = $2 I = $10, $20, $30 An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 5 10 B U2 3 4 A U1 Chapter 4

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 4

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 4

Effects of Income Changes Food (units per month) Clothing (units per month) D 7 16 U3 The Income Consumption Curve traces out the utility maximizing market basket for each income level 5 10 B U2 Income Consumption Curve 3 4 A U1 Chapter 4

Effects of Income Changes Price of 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. 16 D3 H 10 D2 G 4 D1 E $1.00 Food (units per month) Chapter 4

Individual Demand 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 Chapter 4 4

Individual Demand 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 Chapter 4 4

An Inferior Good Steak (units per month) 30 5 20 10 10 5 Hamburger C Both hamburger and steak behave as a normal good, between A and B... Income-Consumption Curve 5 20 10 B U2 …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. 10 5 A U1 Chapter 4

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 4

Engel Curves 30 10 20 4 8 12 16 Income ($ per month) Food (units Engel curves slope upward for normal goods. Chapter 4

Engel Curves 30 10 20 4 8 12 16 Inferior Normal Income ($ per month) Food (units per month) 30 10 Income ($ per month) 20 4 8 12 16 Inferior Engel curves are backward bending for inferior goods. Normal Chapter 4

Annual US Household Consumer Expenditures Chapter 4

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 4

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 4

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 4

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 4

Income and Substitution Effects A change in the price of a good has two effects: Substitution Effect Income Effect Chapter 4

Income and Substitution Effects 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

Income and Substitution Effects Income Effect Consumers experience an increase in real purchasing power when the price of one good falls Chapter 4

Income and Substitution Effects 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

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

Income and Substitution Effects Income Effect Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect Chapter 4

Income and Substitution Effects: Normal Good Clothing (units per month) C2 F2 T U2 B When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. R F1 S C1 A U1 E Total Effect Substitution Effect D The substitution effect, F1E, (from point A to D), changes the relative prices but keeps real income (satisfaction) constant. The income effect, EF2, (from D to B) keeps relative prices constant but increases purchasing power. Income Effect Food (units per month) O Chapter 4

Income and Substitution Effects: Inferior Good Clothing (units per month) Total Effect Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. B Income Effect U2 R A D Substitution Effect U1 Food (units per month) O F1 E S F2 T 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

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

Determining the Market Demand Curve Price A B C Market Demand 1 6 10 16 32 2 4 8 13 25 3 18 7 11 5 Chapter 4

Summing to Obtain a Market Demand Curve 1 2 3 4 Price 5 The market demand curve is obtained by summing the consumer’s demand curves DC DB Market Demand DA Quantity 5 10 15 20 25 30 Chapter 4

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

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

Market Demand Price Elasticity of Demand Measures the percentage change in the quantity demanded resulting from a percent change in price Chapter 4

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

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

Price Elasticity and Consumer Expenditure Chapter 4

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

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

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

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

The Aggregate Demand for Wheat Price Total world demand is the horizontal sum of the domestic demand AB and export demand CD. 18 A B Domestic Demand E 16 Above C, export demand is zero, so domestic demand = total demand = AE segment 10 C D Export Demand F Total Demand Wheat Chapter 4

Consumer Surplus Consumers buy goods because it makes them better off Consumer Surplus measures how much better off they are Chapter 4

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

Consumer Surplus - Example Student wants to buy concert tickets Demand 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

Consumer Surplus - Example Price ($ per ticket) The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. 20 19 18 17 16 Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 15 14 Market Price 13 Will not buy more than 7 because surplus is negative 1 2 3 4 5 6 Rock Concert Tickets Chapter 4

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

Consumer Surplus Consumer Surplus 20 for the Market Demand 19 18 17 16 Price ($ per ticket) Consumer Surplus for the Market Demand 20 19 Demand Curve 18 CS = ½ ($20 - $14)*(1600) = $19,500 17 16 Consumer Surplus 15 14 Market Price Actual Expenditure 13 1 2 3 4 5 6 Rock Concert Tickets Chapter 4

Applying Consumer Surplus Combining consumer surplus with the aggregate profits that producers obtain, we can evaluate: Costs and benefits of different market structures Public policies that alter the behavior of consumers and firms Chapter 4

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

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

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

Valuing Cleaner Air 2000 10 1000 5 A Value NOX (pphm) Pollution Reduction Value The shaded area represents 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. 2000 10 1000 5 A Chapter 4

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

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

Network Externalities If this is the case, a network externality exists Network externalities can be positive or negative Chapter 4

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

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

Positive Network Externality: Bandwagon Effect Price ($ per unit) D20 20 40 D40 60 D60 80 D80 100 D100 When consumers believe more people have purchased the product, the demand curve shifts further to the the right. Quantity (thousands per month) Chapter 4

Positive Network Externality: Bandwagon Effect Price ($ per unit) D20 20 40 D40 60 D60 80 D80 100 D100 The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic. Demand Quantity (thousands per month) Chapter 4

Positive Network Externality: Bandwagon Effect Price ($ per unit) D20 20 40 D40 60 D60 80 D80 100 D100 But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48,000 $30 Demand 48 $20 Bandwagon Effect Pure Price Effect Quantity (thousands per month) Chapter 4

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

Network Externality: Snob Effect Price ($ per unit) Demand Originally demand is D2, when consumers think 2,000 people have bought a good. $30,000 4 6 8 D4 D6 D8 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 Pure Price Effect Quantity (thousands per month) 2 14 Chapter 4

Network Externality: Snob Effect Quantity (thousands per month) Price ($ per unit) 2 Demand D2 $30,000 $15,000 14 4 6 8 D4 D6 D8 Pure Price Effect 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 Snob Effect Chapter 4

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

Empirical Estimation of Demand Problem Consumers may lack information or interest, or be misled by the interviewer Chapter 4

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

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

Demand Data for Raspberries Chapter 4

Empirical Estimation of Demand Assuming only price determines demand: Q = a - bP Q = 28.2 -1.00P Chapter 4

Estimating Demand 25 d1 d2 d3 D D represents demand Price 25 d1 d2 d3 D D represents demand if only P determines demand and then from the data: Q=28.2-1.00P 20 15 10 5 5 10 15 20 25 Quantity Chapter 4

Estimating Demand – Changes in Income Quantity Price 5 10 15 20 25 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

Empirical Estimation of Demand Estimating Elasticities For the demand equation: Q = a - bP Elasticity: Chapter 4

Empirical Estimation of Demand Assuming: Price and income elasticity are constant The isoelastic demand = The slope, -b = price elasticity of demand Constant, c = income elasticity of demand Chapter 4

Empirical Estimation of Demand Using the Raspberry data: Price elasticity = -0.24 (Inelastic) Income elasticity = 1.46 Chapter 4

Empirical Estimation of Demand Complements and Substitutes Substitutes: b2 is positive Complements: b2 is negative Chapter 4

The Demand for Ready-to-Eat Cereal Are Grape Nuts and Spoon Size Shredded Wheat good substitutes? Estimated demand for Grape Nuts (GN) Price elasticity = -2.0 Income elasticity = 0.62 Cross elasticity = 0.14 Chapter 4