1. Chapter 4 Individual and Market Demand Individual and Market Demand

2. Chapter 4Slide 2 Individual Demand The demand curve of an individual consumer follows from the consumption choices that a person makes when faced with a budget constraints Price Changes The impact of a change in the price of food can be illustrated using indifference curves.

3. Chapter 4Slide 3 Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2U2 U3U3 A B D U1U1 41220 Three separate indifference curves are tangent to each budget line. Assume: I = $2000 P C = $200 P F = $200, $100, and $50 10

4. Chapter 4Slide 4 Price-Consumption Curve Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2U2 U3U3 A B D U1U1 41220 The price-consumption curve traces out the utility maximizing of market basket for the various prices for food.

5. Chapter 4Slide 5 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 $200 41220 $100 $50

6. Chapter 4Slide 6 Individual Demand The curve relating the quantity of good that a single consumer will buy to its piece Two Important Properties of Demand Curves 1)The level of utility that can be attained changes as we move along the curve. The Individual Demand Curve

7. Chapter 4Slide 7 Individual Demand 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. The Individual Demand Curve

8. Chapter 4Slide 8 Effect of a Price Change Food (units per month) Price of Food H E G $200 41220 $100 $50 Demand Curve E: P f /P c = 200/200 = 1 = MRS G: P f /P c = 100/2 00=.5 = MRS H:P f /P c = 50/200 =.25 = MRS When the price falls: P f /P c & MRS also fall

9. Chapter 4Slide 9 Individual Demand Income Changes The impact of a change in the income can be illustrated using indifference curves.

10. Chapter 4Slide 10 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. Income-Consumption Curve 3 4 A U1U1 5 10 B U2U2 D 7 16 U3U3 Assume: P f = $100 P c = $200 I = $1000, $2000, $3000

11. Chapter 4Slide 11 Effects of Income Changes Food (units per month) Price of food An increase in income, from $1000 to $2000 to $3000, with the prices fixed, shifts the consumer’s demand curve to the right. $1.00 4 D1D1 E 10 D2D2 G 16 D3D3 H

12. Chapter 4Slide 12 Individual Demand Income Changes The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.

13. Chapter 4Slide 13 Individual Demand Income Changes An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve. at the same time, the increase in income shifts the demand curve to the right.

14. Chapter 4Slide 14 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. Normal Good vs. Inferior Good

15. Chapter 4Slide 15 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. Normal Good vs. Inferior Good

16. Chapter 4Slide 16 An Inferior Good Hamburger (units per month) Steak (units per month) 15 30 U3U3 C Income-Consumption Curve …but hamburger becomes an inferior good when the income consumption curve turns backward between B and C. 10520 5 10 A U1U1 B U2U2 Both hamburger and steak behave as a normal good, between A and B...

17. Chapter 4Slide 17 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.

18. Chapter 4Slide 18 Engel Curves Food (units per month) 3000 4812 1000 Income ($ per month) 2000 160 Engel curves slope upward for normal goods.

19. Chapter 4Slide 19 Engel Curves Engel curves slope backward bending for inferior goods. Hamburger (units per month) 3000 4812 1000 Income ($ per month) 2000 160

20. Chapter 4Slide 20 Individual Demand 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. Substitutes and Complements

21. Chapter 4Slide 21 Individual Demand 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. Substitutes and Complements

22. Chapter 4Slide 22 Individual Demand 3) Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other Substitutes and Complements

23. Chapter 4Slide 23 Individual Demand Substitutes and 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.

24. Chapter 4Slide 24 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.

25. Chapter 4Slide 25 Income and Substitution Effects A fall in the price of a good has two effects: Substitution & Income Income Effect  Because of one good is now cheaper consumer enjoy an increase in real purchasing power.  Consumers experience an increase in real purchasing power when the price of one good falls.

26. Chapter 4Slide 26 Income and Substitution Effects Substitution Effect 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.

27. Chapter 4Slide 27 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.

28. Chapter 4Slide 28 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 constant.

29. Chapter 4Slide 29 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

30. Chapter 4Slide 30 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. From Individual to Market Demand

31. Chapter 4Slide 31 Determining the Market Demand Curve 16101632 2481325 3261018 404711 50246 PriceIndividual AIndividual BIndividual CMarket ($)(units)(units)(units)(units)

32. Chapter 4Slide 32 Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 51015202530 DBDB DCDC Market Demand DADA The market demand curve is obtained by summing the consumer’s demand curves

33. Chapter 4Slide 33 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.

34. Chapter 4Slide 34 Market Demand Elasticity of Demand Price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent change in price.

35. Chapter 4Slide 35 Price Elasticity and Consumer Expenditure DemandIf Price Increases,If Price Decreases,Expenditures: Inelastic (E p <1)IncreaseDecrease Unit Elastic (E p = 1) Are unchangedAre unchanged Elastic (E p >1) DecreaseIncrease

36. Chapter 4Slide 36 Market Demand Arc Elasticity of Demand Arc elasticity calculates elasticity over a range of prices Its formula is:

37. Chapter 4Slide 37 Market Demand Arc Elasticity of Demand (An Example)

38. Chapter 4Slide 38 Consumer Surplus The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid.

39. Chapter 4Slide 39 The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 Consumer Surplus Rock Concert Tickets Price ($ per ticket) 23456 13 01 14 15 16 17 18 19 20 Market Price

40. Chapter 4Slide 40 Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller.

41. Chapter 4Slide 41 Network Externalities When a person’s demand may be affected by the number of other people who have purchased the good.

42. Chapter 4Slide 42 Network Externalities If this is the case, a network externality exists. Network externalities can be positive or negative.

43. Chapter 4Slide 43 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.

44. Chapter 4Slide 44 Demand Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D 20 20406080100 D 40 D 60 D 80 D 100 The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic.

45. Chapter 4Slide 45 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.

46. Chapter 4Slide 46 Negative Network Externality: Snob Effect Quantity (thousands per month) 2468 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. Price ($ per unit) D2D2 $30,000 $15,000 14 D4D4 D6D6 D8D8 Demand Pure Price Effect Snob Effect Net Effect

47. Chapter 4Slide 47 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.

48. Chapter 4Slide 48 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.