1. From the optimal choice of a consumer to overall market demand
Consumer demand
From the optimal choice of a consumer to overall market demand

2. Consumer demand
Up until now, we’ve examined how a single consumer chooses the best (most satisfying) bundle out of the set of affordable ones
The next step is to derive the demand function for each good:
What amount of each good is chosen for each level of its price?
Then, we need to see how all the individual demand functions add up to the market demand for that good

3. Consumer demand Deriving consumer demand
From individual to market demand
Elasticities

4. Deriving consumer demand
As we have seen, given a stable set of preferences, the amount of a good chosen in a bundle depends on :
The price of the good
The price of other goods
The income of the agent
The quantity demanded by the ith agent is therefore a function of these three variables

5. Deriving consumer demand
The effects of a change of income on demand:
The demand for normal goods increases when income increases
Some goods are inferior : The demand for these goods decreases when income increases
If one plots all the quantities demanded for each level of income, one gets the Engel curve

6. Deriving consumer demand C
Income expansion path
Good 1  B A 
Good 2

7. Deriving consumer demand
Other goods E3 E1 E2
150
E’3
100
E’1 50
E’2
DVD
Income
Demand for DVDs
Engel curve

8. Deriving consumer demand
Engel curves
Demand
Demand
Income
Income
Normal good
Inferior good

9. Deriving consumer demand
The effects of a change of price on demand
Generally, because of the substitution effect, the demand for a good varies inversely with its price
Some goods are Giffen goods : The demand for these goods varies in the same direction as price (income effect)
If one plots all the quantities demanded for each level of price, one gets the Demand curve

10. Deriving consumer demand C  B
Good 1
Good 2  A
Price expansion path

11. Deriving consumer demand
Other goods E3 E1 E2 10
E’3 20
E’1 40
E’2
DVD
Price of DVDs
Demand for DVDs
Demand curve

12. Deriving consumer demand
A typical demand curve:
Price1
If the price falls, the individual demands more of the good
Demandof agent i

13. Deriving consumer demand
IMPORTANT NOTE:
The demand function depends on
The price of the good
The price of other goods
The income of the agent
The demand curve only shows a relation between demand and the price of the good
So how do the other variables (income, the price of other goods) affect the demand curve?

14. Deriving consumer demand
The effect of income changes on the demand curve
Price1
If the income increases, the demand increases (at constant price)
If the income falls, the demand falls (at constant price)
Demandof agent i

15. Deriving consumer demand
The effect of a change in another price on the demand curve...
Price1
... is ambiguous !!
It depends on the relative size of the income and substitution effects (Of opposite directions here)
This in turn depends on whether the 2 goods are substitutes or complements
Demandof agent i

16. Consumer demand Deriving consumer demand
From individual to market demand
Elasticities

17. From individual to market demand
Market demand is the aggregate quantity demanded at a given price level
It is not the demand of a single individual, but that of all the agents in the economy
The market demand for a good depends on the relative price of that good and the distribution of all the incomes in the economy

18. From individual to market demand
A simple 2-agent example
Price
Agent 1’s demand
Agent 2’s demand
Market demand

19. From individual to market demand
A Market demand curve
Price1
If the price falls, the market demand for the good increases
Market Demand

20. Consumer demand Deriving consumer demand
From individual to market demand
Elasticities

21. Elasticities
The concept of an elasticity is central to microeconomic theory :
Up until now, we have reasoned in qualitative terms.
A demand curve is downward sloping
It moves upwards if income increases
If we want our theory to be useful in the real world, we need to quantify these concepts.
How sensitive is demand to price /Income ?
Is this the same for all goods ?

22. Elasticities An elasticity is a measure of this sensitivity
It gives the % change in one variable following a % change in another variable
Example : The price elasticity of demand
A price elasticity of demand of -0.5:
An increase in price of 1 % ⇒ fall in demand of 0.5 %
An increase in price of 10 % ⇒ fall in demand of 5 %

23. Elasticities The percentage change of a function is defined as:
This means that we can express the elasticity as:
Slope of the demand function
Price/Demand ratio

24. Price elasticity of a linear demand curve
Elasticities
Price elasticity of a linear demand curve
Price
Quantity
Slope of the demand function
Price/Demand ratio p ∂p
∂Qd
Demand Qd

25. Elasticities The demand function has 3 variables:
We now have measure of sensitivity for all these variables:
The price of the good
Price elasticity of demand (which you already know)
The price of other goods
Cross price elasticity of demand
The income of the agent
Income elasticity of demand

26. Elasticities The price elasticity of demand: Is negative in general
An increase in price reduces the quantity demanded
Is positive for Giffen goods
Demand is price-elastic if the price elasticity is greater than 1 in magnitude
10 % increase in price ⇒ >10% fall in demand
Demand is price-inelastic if the price elasticity is smaller than 1 in magnitude
10 % increase in price ⇒ <10% fall in demand

27. Elasticities The cross price elasticity of demand
Measures the variation of the quantity demanded following an increase in the price of another good
This gives information on whether the goods are substitutes or complements
Example : what is the effect of the increase in fuel prices on the demand for Hummers ??

28. Elasticities The cross price elasticity of demand
Is negative in for complement goods
Example : ↑ price of fuel ⇒ ↓ demand for cars
Is positive for substitute goods
Example : ↑ price of coffee ⇒ ↑ demand for tea
The magnitude of the elasticity gives information on the strength of the link
A large magnitude (>1) means a strong complement / substitute link
A small magnitude (<1) means a weak link
A magnitude close to 0 means no link

29. Elasticities The income elasticity of demand
measures the variation of the quantity demanded following an increase in income of agents
Is negative in for inferior goods
An increase in income reduces the quantity demanded
Is positive for normal goods
An increase in income increases the quantity demanded
Is greater than one for “luxury” goods
An increase in income increases the quantity demanded more than proportionately