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

Topics to be Discussed Network Externalities Empirical Estimation of Demand Chapter 4 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 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

Consumer Expenditures in the United States Income Group (1997 $) Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above Entertainment 700 947 1274 1514 2054 2654 4300 Owned Dwellings 1116 1725 2253 3243 4454 5793 9898 Rented Dwellings 1957 2170 2371 2536 2137 1540 1266 Health Care 1031 1697 1918 1820 2052 2214 2642 Food 2656 3385 4109 4888 5429 6220 8279 Clothing 859 978 1363 1772 1778 2614 3442

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

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

Effect of a Gasoline Tax With a Rebate Assume Ped = -0.5 Income = $9,000 Price of gasoline = $1 Chapter 4

Effect of a Gasoline Tax With a Rebate Expenditures On Other Goods ($) J F H 913.5 After Gasoline Tax Plus Rebate U3 $450 REBATE New budget line Consumer is worse off A C Gasoline = 1200 gallons Other expenditures = $7800 U2 1200 Original Budget Line B D U1 900 After Gasoline Tax E $.50 Excise Tax Gasoline = 900 gallons Gasoline Consumption (gallons/year) Chapter 4

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

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. Chapter 4

Price Elasticity and Consumer Expenditure Demand If Price Increases, If Price Decreases, Expenditures: Expenditures: Inelastic (Ep <1) Increase Decrease Unit Elastic (Ep = 1) Are unchanged Are unchanged Elastic (Ep >1) Decrease Increase Chapter 4

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

Market Demand Point Elasticity of Demand Point elasticity measures elasticity at a point on the demand curve. Its formula is: Chapter 4

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

Point Elasticity of Demand (An Example) 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

Point Elasticity of Demand (An Example) 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

Market Demand Arc Elasticity of Demand Arc elasticity calculates elasticity over a range of prices Its formula is: Chapter 4

Market Demand Arc Elasticity of Demand (An Example) Chapter 4

The Aggregate Demand For Wheat An Example: The Aggregate Demand For Wheat The demand for U.S. wheat is comprised of domestic demand and export demand. Chapter 4

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

The Aggregate Demand For Wheat Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4). Chapter 4

The Aggregate Demand For Wheat Price ($/bushel) 20 18 Total world demand is the horizontal sum of the domestic demand AB and export demand CD. F Total Demand E 16 A B Domestic Demand 14 12 10 C D Export Demand 8 6 4 2 Wheat(million bushels/yr.) 1000 2000 3000 4000 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

The Value of Clean Air An Example: 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 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

Valuing Cleaner Air 2000 10 1000 5 A Value ($ per pphm of reduction) NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 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. 2000 10 1000 5 A Chapter 4

Network Externalities Up to this point we have assumed that people’s demands for a good are independent of one another. If fact, a person’s demand may be affected by the number of other people who have purchased the good. 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). Chapter 4

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

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 (thousands per month) 20 40 60 80 100 Chapter 4

Positive Network Externality: Bandwagon Effect Price ($ per unit) D20 D40 D60 D80 D100 Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48,000 $30 Demand $20 Pure Price Effect Quantity (thousands per month) 20 40 48 60 80 100 Chapter 4

Positive Network Externality: Bandwagon Effect Price ($ per unit) D20 D40 D60 D80 D100 But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. $30 Demand $20 Pure Price Effect Bandwagon Effect Quantity (thousands per month) 20 40 48 60 80 100 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

Negative Network Externality: Snob Effect Price ($ per unit) 2 D2 $30,000 $15,000 14 Pure Price Effect Originally demand is D2, when consumers think 2000 people have bought a good. Demand 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. Quantity (thousands per month) Chapter 4

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

Network Externalities and the Demands for Computers and Fax Machines Examples of Positive Feedback Externalities Mainframe computers: 1954 - 1965 Microsoft Windows PC operating system Fax-machines and e-mail 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 mislead 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 Year Quantity (Q) Price (P) Income(I) 1988 4 24 10 1989 7 20 10 1990 8 17 10 1991 13 17 17 1992 16 10 17 1993 15 15 17 1994 19 12 20 1995 20 9 20 1996 22 5 20 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 Adjusting for changes in income 5 10 15 20 25 D d1 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 Estimating Elasticities Assuming: Price & income elasticity are constant The isoelastic demand = The slope, -b = price elasticity of demand Constant, c = income elasticity Chapter 4

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

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

The Demand for Ready-to-Eat Cereal What Do You Think? Are Grape Nuts & Spoon Size Shredded Wheat good substitutes? Chapter 4

The Demand for Ready-to-Eat Cereal Answer Estimated demand for Grape Nuts (GN) Price elasticity = -2.0 Income elasticity = 0.62 Cross elasticity = 0.14 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. 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. The percent change in quantity demanded that results from a one percent change in price determines elasticity of demand. Chapter 4

Summary There is a network externality when one person’s 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

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