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

2. Topics to be Discussed Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Chapter 4 2

3. Topics to be Discussed Network Externalities
Empirical Estimation of Demand
Chapter 4 3

4. 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.
Chapter 4 4

5. Effect of a Price Change
Clothing
(units per
month)
Assume:
I = $20
PC = $2
PF = $2, $1, $.50 10 4 5 6 U2 U3 A B D U1 12 20
Three separate
indifference curves
are tangent to
each budget line.
Food (units
per month)
Chapter 4 4

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

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

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

9. The Individual Demand Curve
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.
Chapter 4 4

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

11. 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.
Chapter 4 4

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

13. 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. 16 D3 H 10 D2 G 4 D1 E
$1.00
Food (units
per month)
Chapter 4

14. 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

15. 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

16. Normal Good vs. Inferior Good
Individual Demand
Normal Good vs. Inferior Good
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. Normal Good vs. Inferior Good
Individual Demand
Normal Good vs. Inferior Good
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 15 30 Steak (units per month) 10 5 20 HamburgerC
Steak
(units per
month)
Income-Consumption
Curve
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C. 10 5 20 A U1 B U2
Both hamburger
and steak behave
as a normal good,
between A and B...
Hamburger
(units per month)
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 20 10 4 8 12 16 Income ($ per month) Food (units
Engel curves slope
upward for
normal goods. 30 20 10
Food (units
per month) 4 8 12 16
Chapter 4

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

22. Consumer Expenditures in the United States
Income Group (1997 $)
Expenditure Less than 1, , , , , ,000-
($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above
Entertainment
Owned Dwellings
Rented Dwellings
Health Care
Food
Clothing

23. Substitutes and Complements
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. movie tickets and video rentals
Chapter 4 4

24. Substitutes and Complements
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. gasoline and motor oil
Chapter 4 4

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

26. 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!
Chapter 4 4

27. 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.
Chapter 4

28. Income and Substitution Effects
A fall in the price of a good has two effects: Substitution & Income
Income Effect
Consumers experience an increase in real purchasing power when the price of one good falls.
Chapter 4

29. 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.
Chapter 4

30. 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

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

32. 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

33. 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

34. 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

35. Effect of a Gasoline Tax With a Rebate
Assume
Ped = -0.5
Income = $9,000
Price of gasoline = $1
Chapter 4

36. Effect of a Gasoline Tax With a Rebate
Expenditures
On Other
Goods ($) J F H
913.5
After Gasoline Tax
Plus Rebate U3
$450 REBATE
New budget line
Consumer is worse off A C
Gasoline = 1200 gallons
Other expenditures = $7800 U2
1200
Original Budget
Line B D U1
900
After
Gasoline
Tax E
$.50 Excise Tax
Gasoline = 900 gallons
Gasoline Consumption
(gallons/year)
Chapter 4

37. From Individual to 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.
Chapter 4

38. Determining the Market Demand Curve
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)
Chapter 4

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

40. 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.
Chapter 4

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

42. Price Elasticity and Consumer Expenditure
Demand If Price Increases, If Price Decreases,
Expenditures: Expenditures:
Inelastic (Ep <1) Increase Decrease
Unit Elastic (Ep = 1) Are unchanged Are unchanged
Elastic (Ep >1) Decrease Increase
Chapter 4

43. Market Demand Point Elasticity 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.
Chapter 4

44. Market Demand Point Elasticity of Demand
Point elasticity measures elasticity at a point on the demand curve.
Its formula is:
Chapter 4

45. Market Demand Problems Using Point Elasticity
We may need to calculate price elasticity over portion of the demand curve rather than at a single point.
The price and quantity used as the base will alter the price elasticity of demand.
Chapter 4

46. Point Elasticity of Demand (An Example)
Market Demand
Point Elasticity of Demand (An Example)
Assume
Price increases from 8$ to $10 quantity demanded falls from 6 to 4
Percent change in price equals: $2/$8 = 25% or $2/$10 = 20%
Percent change in quantity equals: /6 = % or -2/4 = -50%
Chapter 4

47. Point Elasticity of Demand (An Example)
Market Demand
Point Elasticity of Demand (An Example)
Elasticity equals:
-33.33/.25 = or -.50/.20 = -2.54
Which one is correct?
Chapter 4

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

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

50. The Aggregate Demand For Wheat
An Example:
The Aggregate Demand For Wheat
The demand for U.S. wheat is comprised of domestic demand and export demand.
Chapter 4

51. 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

52. The Aggregate Demand For Wheat
Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4).
Chapter 4

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

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

55. 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
= 21 15 14
Market Price 13 1 2 3 4 5 6
Rock Concert Tickets
Chapter 4

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

57. Consumer Surplus Consumer Surplus 20 for the Market Demand 19 18 17 16
Price
($ per
ticket)
Consumer Surplus
for the Market Demand 20
Demand Curve 19 18 17 16
Consumer
Surplus
Actual
Expenditure 15 14
Market Price 13 1 2 3 4 5 6
Rock Concert Tickets
Chapter 4

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

59. The Value of Clean Air An Example:
Air is free in the sense that we don’t pay to breathe it.
The Clean Air Act was amended in
Question: Were the benefits of cleaning up the air worth the costs?
Chapter 4

60. 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.
Chapter 4

61. Valuing Cleaner Air 2000 10 1000 5 A Value ($ per pphm of reduction)
NOX (pphm)
Pollution Reduction
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 10
1000 5 A
Chapter 4

62. Network Externalities
Up to this point we have assumed that people’s demands for a good are independent of one another.
If fact, a person’s demand may be affected by the number of other people who have purchased the good.
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).
Chapter 4

66. Positive Network Externality: Bandwagon Effect40
When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right .
D40
Price
($ per
unit)
D20 20 60
D60 80
D80
100
D100
Quantity
(thousands per month)
Chapter 4

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

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

69. Positive Network Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40
D60
D80
D100
But as more people buy
the good, it becomes
stylish to own it and
the quantity demanded
increases further.
$30
Demand
$20
Pure Price
Effect
Bandwagon
Effect
Quantity
(thousands per month) 20 40 48 60 80
100
Chapter 4

70. 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

71. Negative Network Externality: Snob Effect
Price
($ per
unit) 2 D2
$30,000
$15,000 14
Pure Price Effect
Originally demand is D2,
when consumers think 2000
people have bought a good.
Demand 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.
Quantity (thousands
per month)
Chapter 4

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

73. Network Externalities and the Demands for Computers and Fax Machines
Examples of Positive Feedback Externalities
Mainframe computers:
Microsoft Windows PC operating system
Fax-machines and
Chapter 4

74. 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

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

76. 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

77. 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

78. Demand Data for Raspberries
Year Quantity (Q) Price (P) Income(I)
Chapter 4

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

80. 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

81. Estimating Demand Adjusting for changes in income 5 10 15 20 25 D d1
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

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

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

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

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

86. The Demand for Ready-to-Eat Cereal
What Do You Think?
Are Grape Nuts & Spoon Size Shredded Wheat good substitutes?
Chapter 4

87. The Demand for Ready-to-Eat Cereal
Answer
Estimated demand for Grape Nuts (GN)
Price elasticity = -2.0
Income elasticity = 0.62
Cross elasticity = 0.14
Chapter 4

88. Summary
Individual consumers’ demand curves for a commodity can be derived from information about their tastes for all goods and services and from their budget constraints.
Engel curves describe the relationship between the quantity of a good consumed and income.
Chapter 4

89. 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.
Chapter 4

90. 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.
The effect of a price change on the quantity demanded can be broken into a substitution effect and an income effect.
Chapter 4

91. 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.
Chapter 4

92. Summary
There is a network externality when one person’s demand is affected directly by the purchasing decisions of other consumers.
A number of methods can be used to obtain information about consumer demand.
Chapter 4

93. Individual and Market Demand
End of Chapter 4
Individual and
Market Demand 1