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

2. Topics to be Discussed Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Empirical Estimation of Demand
Chapter 4 2

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
For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves
Chapter 4 4

4. Effect of a Price Change
Food (units
per month)
Clothing
Assume:
I = $20
PC = $2
PF = $2, $1, $0.50 6 A U1 4 10 4 U2 B 12 20 5 U3 D
Each price leads to different amounts of food purchased
Chapter 4 4

5. Effect of a Price Change4 U2 B 12 20 5 U3 D
Food (units
per month)
Clothing 6 A U1 10
The Price-Consumption Curve traces out the utility maximizing market basket for each price of food
Chapter 4 4

6. Effect of a Price Change
By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual
From the previous example:
Demand Schedule P Q
$2.00 4
$1.00 12
$0.50 20
Chapter 4

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

8. Demand Curves – Important Properties
The level of utility that can be attained changes as we move along the curve
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

9. Effect of a Price Change
Food (units
per month)
Price
of Food
When the price falls,
Pf /Pc & MRS also fall H E G
$2.00 4 12 20
$1.00
$.50
Demand Curve
E: Pf /Pc = 2/2 = 1 = MRS
G: Pf /Pc = 1/2 = .5 = MRS
H:Pf /Pc = .5/2 = .25 = MRS
Chapter 4 4

10. 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
Changing income, with prices fixed, causes consumers to change their market baskets
Chapter 4 4

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

12. 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

13. 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

14. Effects of Income Changes
Food (units
per month)
Clothing
(units per
month) D 7 16 U3
The Income Consumption Curve traces out the utility maximizing market basket for each income level 5 10 B U2
Income Consumption Curve 3 4 A U1
Chapter 4

15. 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 as well. 16 D3 H 10 D2 G 4 D1 E
$1.00
Food (units
per month)
Chapter 4

16. 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
Chapter 4 4

17. 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
Chapter 4 4

18. An Inferior Good Steak (units per month) 30 5 20 10 10 5 HamburgerC
Both hamburger
and steak behave
as a normal good,
between A and B...
Income-Consumption
Curve 5 20 10 B U2
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C. 10 5 A U1
Chapter 4

19. 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

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

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

22. Annual US Household Consumer Expenditures
Chapter 4

23. Substitutes & Complements
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
Ex: movie tickets and video rentals
Chapter 4 4

24. Substitutes & Complements
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
Ex: gasoline and motor oil
Chapter 4 4

25. Substitutes & Complements
If two goods are independent, then a change in the price of one good has no effect on the quantity demanded of the other
Ex: price of chicken and price of airplane tickets
Chapter 4 4

26. Substitutes & 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
They could be both
Chapter 4 4

27. Income and Substitution Effects
A change in the price of a good has two effects:
Substitution Effect
Income Effect
Chapter 4

28. Income and Substitution Effects
Relative price of a good changes when price changes
Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive
Chapter 4

29. Income and Substitution Effects
Income Effect
Consumers experience an increase in real purchasing power when the price of one good falls
Chapter 4

30. 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 demanded of the good
Chapter 4

31. 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

32. Income and Substitution Effects
Income Effect
Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect
Chapter 4

33. 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

34. 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

35. 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

36. 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
The sum of all the individual demand curves in the market
Chapter 4

37. Determining the Market Demand Curve
Price A B C
Market Demand 1 6 10 16 32 2 4 8 13 25 3 18 7 11 5
Chapter 4

38. Summing to Obtain a Market Demand Curve1 2 3 4
Price 5
The market demand
curve is obtained by
summing the consumer’s
demand curves DC DB
Market Demand DA
Quantity 5 10 15 20 25 30
Chapter 4

39. Market Demand From this analysis one can see two important points:
The market demand will shift to the right as more consumers enter the market
Factors that influence the demands of many consumers will also affect the market demand
Chapter 4

40. Market Demand
Aggregation is important to be able to discuss regarding demand for different groups
Households with children
Consumers aged 20 – 30, etc.
Chapter 4

41. Market Demand Price Elasticity of Demand
Measures the percentage change in the quantity demanded resulting from a percent change in price
Chapter 4

42. Price Elasticity of Demand
Inelastic Demand
Ep is less than 1 in absolute value
Quantity demanded is relatively unresponsive to a change in price
|%Q| < |%P|
Total expenditure (P*Q) increases when price increases
Chapter 4

43. Price Elasticity of Demand
Elastic Demand
Ep is greater than than 1 in absolute value
Quantity demanded is relatively responsive to a change in price
|%Q| > |%P|
Total expenditure (P*Q) decreases when price increases
Chapter 4

44. Price Elasticity and Consumer Expenditure
Chapter 4

45. Price Elasticity of Demand
Isoelastic Demand
When price elasticity of demand is constant along the entire demand curve
Demand curve is bowed inward (not linear)
Chapter 4

46. The Aggregate Demand for Wheat
The demand for US wheat is comprised of two components:
Domestic demand
Export demand
Total demand for wheat can be obtained by aggregating these two demands
Chapter 4

47. The Aggregate Demand for Wheat
The domestic demand for wheat is given by the equation:
QDD = P
The export demand for wheat is given by the equation:
QDE = P
Chapter 4

48. The Aggregate Demand for Wheat
Domestic demand is relatively price inelastic (Ed = -0.2)
Export demand is more price elastic (Ed = -0.4)
Poorer countries that import US wheat turn to other grains and food if wheat prices increase
Chapter 4

49. The Aggregate Demand for Wheat
Price
Total world demand is
the horizontal sum of the
domestic demand AB and
export demand CD. 18 A B
Domestic
Demand E 16
Above C, export demand is zero, so domestic demand = total demand = AE segment 10 C D
Export
Demand F
Total Demand
Wheat
Chapter 4

50. Consumer Surplus Consumers buy goods because it makes them better off
Consumer Surplus measures how much better off they are
Chapter 4

51. Consumer Surplus Consumer Surplus
The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid
Can calculate consumer surplus from the demand curve
Chapter 4

52. Consumer Surplus - Example
Student wants to buy concert tickets
Demand curve tells us willingness to pay for each concert ticket
1st ticket worth $20 but price is $14 so student generates $6 worth of surplus
Can measure this for each ticket
Total surplus is addition of surplus for each ticket purchased
Chapter 4

53. Consumer Surplus - Example
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
= 21 15 14
Market Price 13
Will not buy more than 7 because surplus is negative 1 2 3 4 5 6
Rock Concert Tickets
Chapter 4

54. Consumer Surplus
The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller
Consumer surplus is the area under the demand curve and above the price
Chapter 4

55. Consumer Surplus Consumer Surplus 20 for the Market Demand 19 18 17 16
Price
($ per
ticket)
Consumer Surplus
for the Market Demand 20 19
Demand Curve 18
CS = ½ ($20 - $14)*(1600) = $19,500 17 16
Consumer
Surplus 15 14
Market Price
Actual
Expenditure 13 1 2 3 4 5 6
Rock Concert Tickets
Chapter 4

56. Applying Consumer Surplus
Combining consumer surplus with the aggregate profits that producers obtain, we can evaluate:
Costs and benefits of different market structures
Public policies that alter the behavior of consumers and firms
Chapter 4

57. Applying Consumer Surplus – An Example
The Value of Clean Air
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

58. The Value of Clean Air
Empirical data determined estimates for the demand for clean air
No market exists for clean air, but can see people are willing to pay for it
Ex: People pay more to buy houses where the air is clean
Chapter 4

59. The Value of Cleaner Air
Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve
Chapter 4

60. Valuing Cleaner Air 2000 10 1000 5 A Value
NOX (pphm)
Pollution Reduction
Value
The shaded area represents 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

61. Value of Cleaner Air
A full cost-benefit analysis would include total benefit of cleanup
Total benefits would be compared to total costs to determine if the clean up was worthwhile
Chapter 4

62. Network Externalities
Up to this point we have assumed that people’s demands for a good are independent of one another
For some goods, one person’s demand also depends on the demands of other people
Chapter 4

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

64. 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

65. 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)
Positive network externality in which a consumer wishes to possess a good in part because others do
Chapter 4

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

67. Positive Network Externality: Bandwagon Effect
Price
($ per
unit)
D20 20 40
D40 60
D60 80
D80
100
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)
Chapter 4

68. Positive Network Externality: Bandwagon Effect
Price
($ per
unit)
D20 20 40
D40 60
D60 80
D80
100
D100
But as more people buy
the good, it becomes
stylish to own it and
the quantity demanded
increases further.
Suppose the price falls
from $30 to $20. If there
were no bandwagon effect,
quantity demanded would
only increase to 48,000
$30
Demand 48
$20
Bandwagon
Effect
Pure Price
Effect
Quantity
(thousands per month)
Chapter 4

69. 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

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

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

72. 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

73. Empirical Estimation of Demand
Problem
Consumers may lack information or interest, or be misled by the interviewer
Chapter 4

74. 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

75. 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

76. Demand Data for Raspberries
Chapter 4

77. Empirical Estimation of Demand
Assuming only price determines demand:
Q = a - bP
Q = P
Chapter 4

78. 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= P 20 15 10 5 5 10 15 20 25
Quantity
Chapter 4

79. Estimating Demand – Changes in Income
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 = P + .81I
Chapter 4

80. Empirical Estimation of Demand
Estimating Elasticities
For the demand equation: Q = a - bP
Elasticity:
Chapter 4

81. Empirical Estimation of Demand
Assuming: Price and income elasticity are constant
The isoelastic demand =
The slope, -b = price elasticity of demand
Constant, c = income elasticity of demand
Chapter 4

82. Empirical Estimation of Demand
Using the Raspberry data:
Price elasticity = (Inelastic)
Income elasticity = 1.46
Chapter 4

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

84. The Demand for Ready-to-Eat Cereal
Are Grape Nuts and Spoon Size Shredded Wheat good substitutes?
Estimated demand for Grape Nuts (GN)
Price elasticity = -2.0
Income elasticity = 0.62
Cross elasticity = 0.14
Chapter 4