Individual and Market Demand Chapter 4 Individual and Market Demand 1

Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus 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. Chapter 4 4

Effect of a Price Change Clothing (units per month) Assume: I = $20 PC = $2 PF = $2, $1, $.50 10 4 5 6 U2 U3 A B D U1 12 20 Three separate indifference curves are tangent to each budget line. Food (units per month) Chapter 4 4

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. 6 A Price-Consumption Curve U1 5 D B 4 U3 U2 Food (units per month) 4 12 20 Chapter 4 4

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

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 4

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 4

Effect of a Price Change of Food Demand 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 H E G $2.00 4 12 20 $1.00 $.50 Food (units per month) 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. Chapter 4 4

Effects of Income Changes Clothing (units per month) D 7 16 U3 Assume: Pf = $1 Pc = $2 I = $10, $20, $30 5 10 B U2 Income-Consumption Curve An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 4 A U1 Food (units per month) 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. 16 D3 H 10 D2 G 4 D1 E $1.00 Food (units per month) 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

Normal Good vs. Inferior Good 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. Chapter 4 4

Normal Good vs. Inferior Good 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. Chapter 4 4

An Inferior Good 15 30 Steak (units per month) 10 5 20 Hamburger C Steak (units per month) Income-Consumption Curve …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. 10 5 20 A U1 B U2 Both hamburger and steak behave as a normal good, between A and B... Hamburger (units per month) 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 20 10 4 8 12 16 Income ($ per month) Food (units Engel curves slope upward for normal goods. 30 20 10 Food (units per month) 4 8 12 16 Chapter 4

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

Substitutes and Complements 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 Chapter 4 4

Substitutes and Complements 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 Chapter 4 4

Substitutes and Complements 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 4

Individual Demand Substitutes and Complements They could be both! 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

Remember the Effect of a Price Change Clothing (units per month) 6 A Price-Consumption Curve U1 5 D B 4 U3 U2 Food (units per month) 4 12 20 Chapter 4 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

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

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 of the item demanded. 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

A Giffen Good Quantity of Potatoes Initial budget constraint A B I1 Optimum with high price of potatoes I2 Optimum with low price of potatoes D E 2. . . . which increases potato consumption if potatoes are a Giffen good. 1. An increase in the price of potatoes rotates the budget constraint inward . . . C New budget constraint Quantity of Meat Copyright©2004 South-Western

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

Determining the Market Demand Curve Price Individual A Individual B Individual C Market ($) (units) (units) (units) (units) 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

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

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

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

tickets is the sum of the Consumer Surplus 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 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. 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 Demand Curve 19 18 17 16 Consumer Surplus Actual Expenditure 15 14 Market Price 13 1 2 3 4 5 6 Rock Concert Tickets Chapter 4

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

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. 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. The effect of a price change on the quantity demanded can be broken into a substitution effect and an income effect. Chapter 4

Summary The market demand curve is the horizontal summation of the individual demand curves for all consumers. Chapter 4

Individual and Market Demand End of Chapter 4 Individual and Market Demand 1