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 2

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

Individual Demand The Demand Curve The price-consumption curve traces the utility-maximizing combinations of food and clothing associated with each and every price of food. The demand curve relates the quantity of food that the consumer will buy to the price of food. 4

Effect of a Price Change Clothing (units per month) Food (units per month) 4

Effect of a Price Change Clothing (units per month) The budget lines illustrate three prices for food--$2 $2 Food (units per month) 4

Effect of a Price Change Clothing (units per month) The budget lines illustrate three prices for food--$2, $1, $2 $1 Food (units per month) 4

Effect of a Price Change Clothing (units per month) The budget lines illustrate three prices for food--$2, $1, and $.50 $2 $1 $0.50 Food (units per month) 4

Effect of a Price Change Clothing (units per month) Three separate indifference curves are tangent to each budget line. A U1 D B U3 U2 Food (units per month) 4

Effect of a Price Change Clothing (units per month) Three separate indifference curves are tangent to each budget line. 6 A U1 5 D B 4 U3 U2 Food (units per month) 4 12 20 4

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

Effect of a Price Change of Food The points E, G, and H correspond to points A, B, and D, respectively. E $2.00 $1.50 G $1.00 Demand Curve $.50 H Food (units per month) 4 12 20 4

Individual Demand Two Important Properties of Demand Curves 1) The level of utility that can be attained changes as we move along the curve. 4

Individual Demand 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. 4

Individual Demand Income 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. 4

Effects of Income Changes Clothing (units per month) 7 5 3 Food (units per month) 4 10 16

Effects of Income Changes Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 7 5 3 U1 A Food (units per month) 4 10 16

Effects of Income Changes Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 7 5 U2 B 3 U1 A Food (units per month) 4 10 16

Effects of Income Changes Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 7 D U3 5 U2 B 3 U1 A Food (units per month) 4 10 16

Effects of Income Changes Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. Income-Consumption Curve 7 D U3 5 U2 B 3 U1 A Food (units per month) 4 10 16

Effects of Income Changes Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. E $1.00 D1 Food (units per month) 4 10 16

Effects of Income Changes Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. E G $1.00 D2 D1 Food (units per month) 4 10 16

Effects of Income Changes Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. E G H $1.00 D3 D2 D1 Food (units per month) 4 10 16

Individual Demand Income Changes The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level. 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. 4

Individual Demand Income Changes If the income-consumption curve has a positive slope, the quantity demanded increases with income and the income elasticity of demand is positive. The good is a normal good. 4

Individual Demand Income Changes If the income-consumption curve has a negative slope, the quantity demanded decreases with income and the income elasticity of demand is negative. The good is an inferior good. 4

An Inferior Good 15 10 5 5 10 20 30 Steak (units per month) Hamburger

An Inferior Good 15 10 5 5 10 20 30 Steak (units per month) A U1 Hamburger (units per month) 5 10 20 30

An Inferior Good 15 10 5 5 10 20 30 Steak (units per month) Both hamburger and steak behave as a normal good, between A and B... 10 B 5 U2 A U1 Hamburger (units per month) 5 10 20 30

An Inferior Good 15 10 5 5 10 20 30 Steak (units per month) …but hamburger becomes and inferior good when the income consumption curve bends backward between B and C. C 10 U3 B 5 U2 A U1 Hamburger (units per month) 5 10 20 30

An Inferior Good 15 10 5 5 10 20 30 Steak (units per month) Income-Consumption Curve …but hamburger becomes and inferior good when the income consumption curve bends backward between B and C. C 10 U3 B 5 B U2 A U1 Hamburger (units per month) 5 10 20 30

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. 4

Engel Curves 30 20 10 4 8 12 16 Income ($ per month) Food (units 4 8 12 16

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

Engel Curves 30 20 10 5 10 Income ($ per month) Hamburger (units per month) 5 10

Engel Curves 30 20 10 5 10 Income ($ per month) Hamburger Engel curves slope backward bending for inferior goods. 20 10 Hamburger (units per month) 5 10

Engel Curves 30 20 10 5 10 Income ($ per month) Inferior Normal Engel curves slope backward bending for inferior goods. 20 Normal 10 Hamburger (units per month) 5 10

Example: Consume Expenditures in the United States Income Group (1993 $) Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above Entertainment 520 894 1,185 1,602 2,018 2,565 4,007 Owned Dwellings 854 1,370 2,122 3,314 4,450 5,616 9,736 Rented Dwellings 1,642 2,128 1,978 1,884 1,802 1,514 748 Health Care 1,034 1,647 1,732 1,881 2,012 2,054 2,703 Food 2,461 3,198 3,971 4,706 5,556 6,273 8,137 Clothing 867 1,068 1,394 1,778 2,215 2,316 3,668

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. Butter and margarine 4

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. CDs and CD players 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! 4

Income and Substitution Effects A fall in the price of a good has two effects. Consumers experience an increase in real purchasing power. They will tend to consume more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.

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.

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. It usually still increases

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

Income and Substitution Effects--Normal Good Clothing (units per month) Originally, the consumer is at A on budget line RS. R C1 A U1 Food (units per month) O F1 S

Income and Substitution Effects--Normal Good Clothing (units per month) When the price of food falls, consumption increases by F1Fs as the consumer moves to B. R C1 A B C2 U2 U1 Food (units per month) O F1 S F2 T

Income and Substitution Effects--Normal Good Clothing (units per month) The substitution effect,F1E, (from points AD), changes the relative prices but keeps real income constant. R C1 A D B C2 U2 Substitution Effect U1 Food (units per month) O F1 E S F2 T Total Effect

Income and Substitution Effects--Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 The income effect, EF2, (D to B) keeps relative prices constant but increases purchasing power. U2 B E Total Effect Substitution Effect Income Effect D

Income and Substitution Effects--Inferior Good Clothing (units per month) Originally, the consumer is at A on budget line RS. R A U1 Food (units per month) O F1 S

Income and Substitution Effects--Inferior Good Clothing (units per month) The substitution effect,F1E, (from points AD), changes the relative prices but keeps real income constant. R A D Substitution Effect U1 Food (units per month) O F1 E S T

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

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.

Market Demand From Individual to Market Demand Market demand curves are the horizontal summation of the individuals’ demand curves.

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

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

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

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

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

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.

Market Demand Point and Arc Elasticities of Demand Recall: Price elasticity of demand measures the percentage change in the quantity demanded resulting from a percentage change in price.

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

Market Demand Point and Arc Elasticities 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.

Market Demand Point and Arc Elasticities of Demand Point elasticity measures elasticity at a point on the demand curve. Its formula is:

Market Demand Problems Using Point Elasticity We may need to calculate elasticity between two points instead of at a single point. The price and quantity used as the original will alter the price elasticity of demand. Using different original values will result in different calculations.

Market Demand Point and Arc Elasticities of Demand Arc Elasticity: Arc elasticity uses the average of the initial and final price as the original. Its formula is:

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

Example:The Aggregate Demand For Wheat The domestic demand for wheat is given by the equation: QDD = 1354 - 70P The export demand for wheat is given by the equation: QDE = 2031 - 209P

Example:The Aggregate Demand For Wheat Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4 to -0.5).

The Aggregate Demand for Wheat Price ($/bushel) 20 A 18 16 14 12 C 10 8 6 Export Demand 4 Domestic Demand 2 B D 1000 2000 3000 4000 Quantity (millions of bushels per year)

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

Consumer Surplus Consumer surplus is the difference between what a consumer is willing to pay for a good and what the consumer actually pays when buying it.

Consumer Surplus 20 19 18 17 16 15 14 13 1 2 3 4 5 6 Price ($ per ticket) 20 19 18 17 16 15 14 13 1 2 3 4 5 6 Rock Concert Tickets

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 15 Market Price 14 13 1 2 3 4 5 6 Rock Concert Tickets

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 15 Market Price 14 13 1 2 3 4 5 6 Rock Concert Tickets

the quantity purchased. Consumer Surplus Price ($ per ticket) The consumer’s actual expenditure is the price times the quantity purchased. 20 19 18 17 16 Consumer Surplus 15 Market Price 14 13 Actual Expenditure 1 2 3 4 5 6 Rock Concert Tickets

Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller.

parts the consumer surplus Price ($ per ticket) For goods that cannot be divided into small parts the consumer surplus is the yellow area below the demand curve. 20 19 18 17 16 Consumer Surplus 15 Market Price 14 13 Demand Curve Actual Expenditure 1 2 3 4 5 6 Rock Concert Tickets

Consumer Surplus Consumer surplus along with aggregate profits allow us to evaluate: 1) Costs and benefits of different market structures 2) Public policies that alter the behavior of consumers and firms

Example: The Value of Clean Air Air is free in the sense that we need not pay to breathe it. The Clean Air Act was amended in 1970. Question: Were the benefits of cleaning up the air worth the costs?

Example: 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.

Valuing Clean Air 2000 1000 5 10 Value ($ per pphm of reduction) NOX (pphm) Pollution Reduction 5 10

Valuing Clean Air 2000 1000 5 10 Value ($ per pphm of reduction) NOX (pphm) Pollution Reduction 5 10

Valuing Clean Air 2000 A 1000 5 10 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 A 1000 NOX (pphm) Pollution Reduction 5 10