Chapter 4 Individual and Market Demand

©2005 Pearson Education, Inc. Chapter 42 Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Network Externalities

©2005 Pearson Education, Inc. Chapter 43 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

©2005 Pearson Education, Inc. Chapter 44 Effect of a Price Change Each price leads to different amounts of food purchased 5 U3U3 D 4 U2U2 B 1220 Assume: I = $20 P C = $2 P F = $2, $1, $0.50 Food (units per month) Clothing 6 A U1U1 4 10

©2005 Pearson Education, Inc. Chapter 45 Effect of a Price Change The Price- Consumption Curve traces out the utility maximizing market basket for each price of food 4 U2U2 B U3U3 D Food (units per month) Clothing 6 A U1U1 4 10

©2005 Pearson Education, Inc. Chapter 46 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 PQ $ $ $0.504

©2005 Pearson Education, Inc. Chapter 47 Effect of a Price Change Demand Curve Individual Demand relates the quantity of a good that a consumer will buy to the price of that good. Food (units per month) Price of Food H E G $ $1.00 $.50

©2005 Pearson Education, Inc. Chapter 48 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.

©2005 Pearson Education, Inc. Chapter 49 Effect of a Price Change Food (units per month) Price of Food H E G $ $1.00 $.50 Demand Curve E: P f /P c = 2/2 = 1 = MRS G: P f /P c = 1/2 =.5 = MRS H:P f /P c =.5/2 =.25 = MRS When the price falls: P f /P c & MRS also fall

©2005 Pearson Education, Inc. Chapter 410 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 consumer to change their market baskets.

©2005 Pearson Education, Inc. Chapter 411 Effects of Income Changes Food (units per month) Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 4 A U1U B U2U2 D 7 16 U3U3 Assume: P f = $1, P c = $2 I = $10, $20, $30

©2005 Pearson Education, Inc. Chapter 412 Individual Demand Income Changes  The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.

©2005 Pearson Education, Inc. Chapter 413 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.

©2005 Pearson Education, Inc. Chapter 414 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 U1U B U2U2 D 7 16 U3U3 Income Consumption Curve

©2005 Pearson Education, Inc. Chapter 415 Effects of Income Changes Food (units per month) 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. $ D1D1 E 10 D2D2 G 16 D3D3 H

©2005 Pearson Education, Inc. Chapter 416 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.

©2005 Pearson Education, Inc. Chapter 417 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.

©2005 Pearson Education, Inc. Chapter 418 An Inferior Good Hamburger (units per month) Steak (units per month) 30 U3U3 C Income-Consumption Curve …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C A U1U B U2U2 Both hamburger and steak behave as a normal good, between A and B...

©2005 Pearson Education, Inc. Chapter 419 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.

©2005 Pearson Education, Inc. Chapter 420 Engel Curves Food (units per month) Income ($ per month) Engel curves slope upward for normal goods.

©2005 Pearson Education, Inc. Chapter 421 Engel Curves Engel curves are backward bending for inferior goods. Inferior Normal Food (units per month) Income ($ per month)

©2005 Pearson Education, Inc. Chapter 422 Annual US Household Consumer Expenditures

©2005 Pearson Education, Inc. Chapter 423 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

©2005 Pearson Education, Inc. Chapter 424 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

©2005 Pearson Education, Inc. Chapter 425 Substitutes & Complements Two goods are independent then a change in the price of one good has no effect on the quantity demanded of the other  Ex: chicken and airplane tickets

©2005 Pearson Education, Inc. Chapter 426 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.

©2005 Pearson Education, Inc. Chapter 427 Income and Substitution Effects A change in the price of a good has two effects:  Substitution Effect  Income Effect

©2005 Pearson Education, Inc. Chapter 428 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.

©2005 Pearson Education, Inc. Chapter 429 Income and Substitution Effects Income Effect  Consumers experience an increase in real purchasing power when the price of one good falls.

©2005 Pearson Education, Inc. Chapter 430 Income and Substitution Effects Substitution Effect  The substitution effect is the change in a good’s consumption associated with a change in the price of the good, 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.

©2005 Pearson Education, Inc. Chapter 431 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.

©2005 Pearson Education, Inc. Chapter 432 Income and Substitution Effects Income Effect  Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

©2005 Pearson Education, Inc. Chapter 433 Income and Substitution Effects: Normal Good Food (units per month) O Clothing (units per month) R F1F1 S C1C1 A U1U1 The income effect, EF 2, ( from D to B) keeps relative prices constant but increases purchasing power. Income Effect C2C2 F2F2 T U2U2 B When the price of food falls, consumption increases by F 1 F 2 as the consumer moves from A to B. E Total Effect Substitution Effect D The substitution effect,F 1 E, (from point A to D), changes the relative prices but keeps real income (satisfaction) constant.

©2005 Pearson Education, Inc. Chapter 434 Food (units per month) O R Clothing (units per month) F1F1 SF2F2 T A U1U1 E Substitution Effect D 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 U2U2 Income and Substitution Effects: Inferior Good

©2005 Pearson Education, Inc. Chapter 435 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.

©2005 Pearson Education, Inc. Chapter 436 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

©2005 Pearson Education, Inc. Chapter 437 Determining the Market Demand Curve PriceABC Market Demand

©2005 Pearson Education, Inc. Chapter 438 Summing to Obtain a Market Demand Curve Quantity Price DBDB DCDC Market Demand DADA The market demand curve is obtained by summing the consumer’s demand curves

©2005 Pearson Education, Inc. Chapter 439 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.

©2005 Pearson Education, Inc. Chapter 440 Market Demand Aggregation is important to be able to discuss demand for different groups  Households with children  Consumers aged 20 – 30, etc.

©2005 Pearson Education, Inc. Chapter 441 Market Demand Price Elasticity of Demand  Measures the percentage change in the quantity demanded resulting from a percent change in price.

©2005 Pearson Education, Inc. Chapter 442 Price Elasticity of Demand Inelastic Demand  E p is less than 1 in absolute value  Quantity demanded is relative unresponsive to a change in price  %  Q < %  P  Total expenditure (P*Q) increases when price increases

©2005 Pearson Education, Inc. Chapter 443 Price Elasticity of Demand Elastic Demand  E p is greater than than 1 in absolute value  Quantity demanded is relative responsive to a change in price  %  Q > %  P  Total expenditure (P*Q) decreases when price increases

©2005 Pearson Education, Inc. Chapter 444 Price Elasticity and Consumer Expenditure

©2005 Pearson Education, Inc. Chapter 445 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)

©2005 Pearson Education, Inc. Chapter 446 The Aggregate Demand For Wheat The demand for U.S. wheat is comprised of two components  Domestic demand  Export demand Total demand for wheat can be obtained by aggregating these two demands

©2005 Pearson Education, Inc. Chapter 447 The Aggregate Demand For Wheat The domestic demand for wheat is given by the equation:  QDD = P The export demand for wheat is given by the equation:  QDE = P

©2005 Pearson Education, Inc. Chapter 448 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

©2005 Pearson Education, Inc. Chapter 449 C D Export Demand Total world demand is the horizontal sum of the domestic demand AB and export demand CD. F Total Demand A B Domestic Demand E The Aggregate Demand For Wheat Wheat Price Above C, export demand is zero so domestic demand = total demand = AE segment

©2005 Pearson Education, Inc. Chapter 450 Consumer Surplus Consumers buy goods because it makes them better off Consumer Surplus measures how much better off they are

©2005 Pearson Education, Inc. Chapter 451 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

©2005 Pearson Education, Inc. Chapter 452 Consumer Surplus - Example Student wants to buy concert tickets Demand curve tells us willingness to pay for each concert ticket  1 st 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

©2005 Pearson Education, Inc. Chapter 453 The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Consumer Surplus = 21 Consumer Surplus - Example Rock Concert Tickets Price ($ per ticket) Market Price Will not buy more than 7 because surplus is negative

©2005 Pearson Education, Inc. Chapter 454 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 area under the demand curve and above the price

©2005 Pearson Education, Inc. Chapter 455 Demand Curve Consumer Surplus Consumer Surplus for the Market Demand Consumer Surplus Rock Concert Tickets Price ($ per ticket) Actual Expenditure Market Price CS = ½ ($20 - $14)*(1600) = $19,500

©2005 Pearson Education, Inc. Chapter 456 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

©2005 Pearson Education, Inc. Chapter 457 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  Question: Were the benefits of cleaning up the air worth the costs?

©2005 Pearson Education, Inc. Chapter 458 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.

©2005 Pearson Education, Inc. Chapter 459 The Value of Cleaner Air Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve

©2005 Pearson Education, Inc. Chapter 460 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. Valuing Cleaner Air A NOX (pphm) Pollution Reduction Value

©2005 Pearson Education, Inc. Chapter 461 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 worth while

©2005 Pearson Education, Inc. Chapter 462 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

©2005 Pearson Education, Inc. Chapter 463 Network Externalities If this is the case, a network externality exists. Network externalities can be positive or negative.

©2005 Pearson Education, Inc. Chapter 464 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.

©2005 Pearson Education, Inc. Chapter 465 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

©2005 Pearson Education, Inc. Chapter 466 Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D When consumers believe more people have purchased the product, the demand curve shifts further to the the right. 40 D D D D 100

©2005 Pearson Education, Inc. Chapter 467 Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic. 40 D D D D 100 Demand

©2005 Pearson Education, Inc. Chapter 468 Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48, D D D D 100 Demand But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. $30 48 $20 Pure Price Effect Bandwagon Effect

©2005 Pearson Education, Inc. Chapter 469 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.

©2005 Pearson Education, Inc. Chapter 470 Network Externality: Snob Effect Quantity (thousands per month) Price ($ per unit) 2 Demand D2D2 $30,000 $15, Originally demand is D 2, when consumers think 2000 people have bought a good. 468 D4D4 D6D6 D8D8 However, if consumers think 4,000 people have bought the good, demand shifts from D 2 to D 6 and its snob value has been reduced. Pure Price Effect

©2005 Pearson Education, Inc. Chapter 471 Network Externality: Snob Effect Quantity (thousands per month) Price ($ per unit) 2 Demand D2D2 $30,000 $15, D4D4 D6D6 D8D8 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