1. MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 4: Individual and Market Demand

2. Copyright 2012John Wiley & Sons, Inc. 2 Learning Objectives Understand how price changes affect consumption choices. Differentiate between the income and substitution effects associated with a price change on the consumption of a particular good. Explain the relation between income and substitution effects in the case of inferior goods. Show how individual demand curves are aggregated to obtain the market demand curve. (continued)

3. Copyright 2012John Wiley & Sons, Inc. 3 Learning Objectives (continued) Demonstrate how consumer surplus represents the net benefit, or gain, served by an individual from consuming one market basket instead of another. Investigate the relationship between own-price elasticity of demand and the price-consumption curve. Examine network effects: the extent to which an individual consumer’s demand for a good is influenced by other individuals’ purchases. Overview the basics of demand estimation.

4. Copyright 2012John Wiley & Sons, Inc. 4 Price Changes and Consumption Choices Price-consumption curve: a curve that identifies the optimal market basket associated with each possible price of a good, holding constant all other determinants of demand. The consumer’s demand curve can be derived from the price-consumption curve.

5. Figure 4.1 – Derivation of the Consumer’s Demand Curve Copyright 2012John Wiley & Sons, Inc. 5

6. Copyright 2012John Wiley & Sons, Inc. 6 Some Remarks about the Demand Curve The consumer’s level of well-being varies along the demand curve. The prices of other goods are held constant among a demand curve, but the quantities purchased of these other goods can vary. At each point on the demand curve, the consumer’s optimality condition is satisfied: MRS XO = P X /P O where “O” refers to “other goods” (composite good). The demand curve identifies the marginal benefit associated with various levels of consumption.

7. Copyright 2012John Wiley & Sons, Inc. 7 Figure 4.2 - Do Demand Curves Always Slope Downward?

8. Copyright 2012John Wiley & Sons, Inc. 8 Income and Substitution Effects of a Price Change Income effect – a change in a consumer’s real purchasing power brought about by a change in the price of a good Substitution effect – an incentive to increase consumption of a good whose price falls, at the expense of other, now relatively more expensive, goods

9. Income and Substitution Effects Illustrated: The Normal-Good Case Substitution Effect: change in consumption due to a change in relative prices, with no change in real income or well-being Income Effect: change in consumption due to a change in real income or well-being, with no change in relative prices For a normal good, both effects imply more consumption at a lower price and less consumption at a higher price. Demand curve slopes downward. Copyright 2012John Wiley & Sons, Inc. 9

10. Copyright 2012John Wiley & Sons, Inc. 10 Figure 4.3 - Income and Substitution Effects of a Price Reduction: The Normal-Good Case

11. The Income and Substitution Effects Associated with a Gasoline Tax-Plus-Rebate Program Excise Tax – a tax on a specific good Objective: encourage consumers to reduce their use of gasoline What can be done with the tax revenue? Tax rebate to consumers Reduce the government’s outstanding debt Would an excise tax and a tax rebate curtail consumption? Copyright 2012John Wiley & Sons, Inc. 11

12. Copyright 2012John Wiley & Sons, Inc. 12 Figure 4.4 - A Graphical Examination of a Tax-Plus-Rebate Program

13. Income and Substitution Effects Illustrated: Inferior Goods Two possibilities : Substitution effect > income effect Demand curve slopes downward Income effect > substitution effect Demand curve slopes upward Giffen Good Copyright 2012John Wiley & Sons, Inc. 13

14. Copyright 2012John Wiley & Sons, Inc. 14 Figure 4.5 - Income and Substitution Effects for an Inferior Goods

15. From Individual to Market Demand Horizontal summation: add quantities of individual demand curves at each price to obtain the market demand curve All individual demand curves slope downward => market demand curve slopes downward If some individual demand curves slope upward => market demand curve can till slope downward Copyright 2012John Wiley & Sons, Inc. 15

16. Copyright 2012John Wiley & Sons, Inc. 16 Figure 4.6 – Summing Individual Demands to Obtain Market Demand

17. Copyright 2012John Wiley & Sons, Inc. 17 Figure 4.7 - The Aggregate Demand for a UCLA MBA

18. Copyright 2012John Wiley & Sons, Inc. 18 Consumer Surplus Consumer surplus – a measure of the net gain to consumers from purchasing a good arising from its cost being below the maximum that consumers are willing to pay Total benefit – the total value a consumer derives from a particular amount of a good and thus the maximum amount the consumer would be willing to pay for that amount of the good. Marginal benefit – the incremental value a consumer derives from consuming an additional unit of a good and thus the maximum amount the consumer would pay for that additional unit

19. Copyright 2012John Wiley & Sons, Inc. 19 Figure 4. 8 – Consumer Surplus

20. Calculating Consumer Surplus Copyright 2012John Wiley & Sons, Inc. 20 [NOTE: See Figure 4.8]

21. Copyright 2012John Wiley & Sons, Inc. 21 Figure 4.9 - Geometric Calculation of Consumer Surplus

22. Copyright 2012John Wiley & Sons, Inc. 22 Figure 4.10 – The Increase in Consumer Surplus with a Lower Price

23. Copyright 2012John Wiley & Sons, Inc. 23 Figure 4.11 - Consumer Surplus and Indifference Curves

24. Copyright 2012John Wiley & Sons, Inc. 24 Figure 4.12 - Price-Consumption Curves and the Elasticity of Demand

25. Copyright 2012John Wiley & Sons, Inc. 25 Network Effects Network effects – the extent to which an individual consumer’s demand for a good is influenced by other individuals’ purchases Bandwagon effect – a positive network effect Snob effect – a negative network effect

26. The Bandwagon Effect It exists whenever the quantity of a good demanded by a particular consumer is greater the larger the number of other consumers purchasing the same good. It increases the response in quantity demanded to any change in price The market demand is more elastic than the individual demand curves. Copyright 2012John Wiley & Sons, Inc. 26

27. Figure 4.13 - The Bandwagon Effect Copyright 2012John Wiley & Sons, Inc. 27

28. The Snob Effect It occurs when a consumer is less willing to purchase a good the more widespread its usage. The quantity of a good demanded by a particular individual falls the more widely owned the good is considered to be by other consumers. The market demand is more inelastic than the individual demand curves. Copyright 2012John Wiley & Sons, Inc. 28

29. Figure 4.14 - Snob Effect Copyright 2012John Wiley & Sons, Inc. 29

30. Copyright 2012John Wiley & Sons, Inc. 30 The Basics of Demand Estimation Experimentation Limitations: difficult to allow only one factor to change, holding the other factors constant may be incorrect to apply the results obtained from the sample to the entire population Surveys Important to choose a representative sample Reliability is dependent on respondents’ truthfulness Regression analysis (econometrics) – a statistical method that allows one to estimate the sensitivity of the quantity demanded of a good to determinants such as price and income

31. Copyright 2012John Wiley & Sons, Inc. 31 Table 4.1

32. Copyright 2012John Wiley & Sons, Inc. 32 Figure 4.15 - Ordinary Least-Squares Regression

33. Regression Analysis Copyright 2012John Wiley & Sons, Inc. 33

34. Copyright 2012John Wiley & Sons, Inc. 34 Deriving the Consumer’s Demand Curve Mathematically The demand curve of a consumer can be derived from the first-order conditions determining the consumer’s optimal choice: solve for the quantity demanded of the product, as a function of the price The demand curve depends on the exact nature of the consumer’s preferences as expressed in the utility function.

35. Deriving the Consumer’s Demand Curve Mathematically [Equations] Copyright 2012John Wiley & Sons, Inc. 35

36. The Cobb-Douglas Utility Function [Equations] [continued] Copyright 2012John Wiley & Sons, Inc. 36

37. The Cobb-Douglas Utility Function [Equations] Copyright 2012John Wiley & Sons, Inc. 37 [continued]

38. Copyright 2012John Wiley & Sons, Inc. 38 Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back- up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.