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Chapter 4 Individual and Market Demand Individual and Market Demand.

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Presentation on theme: "Chapter 4 Individual and Market Demand Individual and Market Demand."— Presentation transcript:

1 Chapter 4 Individual and Market Demand Individual and Market Demand

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

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

4 Chapter 4Slide 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.

5 Chapter 4Slide 5 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 = $20 P C = $2 P F = $2, $1, $.50 10

6 Chapter 4Slide 6 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 market basket for the various prices for food.

7 Chapter 4Slide 7 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 $2.00 41220 $1.00 $.50

8 Chapter 4Slide 8 Individual Demand 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

9 Chapter 4Slide 9 Individual Demand 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. The Individual Demand Curve

10 Chapter 4Slide 10 Effect of a Price Change Food (units per month) Price of Food H E G $2.00 41220 $1.00 $.50 Demand Curve E: P f /P c = 2/2 = 1 = MRS G: P f /P c = 1/2 =.5 = MRS H:P f /P c =.5/2 =.25 = MRS When the price falls: P f /P c & MRS also fall

11 Chapter 4Slide 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.

12 Chapter 4Slide 12 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 = $1 P c = $2 I = $10, $20, $30

13 Chapter 4Slide 13 Effects of Income Changes Food (units per month) Price of food An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumers demand curve to the right. $1.00 4 D1D1 E 10 D2D2 G 16 D3D3 H

14 Chapter 4Slide 14 Individual Demand Income Changes The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.

15 Chapter 4Slide 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.

16 Chapter 4Slide 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. Normal Good vs. Inferior Good

17 Chapter 4Slide 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. Normal Good vs. Inferior Good

18 Chapter 4Slide 18 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 bends 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...

19 Chapter 4Slide 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.

20 Chapter 4Slide 20 Engel Curves Food (units per month) 30 4812 10 Income ($ per month) 20 160 Engel curves slope upward for normal goods.

21 Chapter 4Slide 21 Engel Curves Engel curves slope backward bending for inferior goods. Inferior Normal Food (units per month) 30 4812 10 Income ($ per month) 20 160

22 Consumer Expenditures in the United States Entertainment70094712741514205426544300 Owned Dwellings1116172522533243445457939898 Rented Dwellings1957217023712536213715401266 Health Care1031169719181820205222142642 Food2656338541094888542962208279 Clothing85997813631772177826143442 ExpenditureLess than1,000-20,000-30,000-40,000-50,000-70,000- ($) on:$10,00019,00029,00039,00049,00069,000and above Income Group (1997 $)

23 Chapter 4Slide 23 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. e.g. movie tickets and video rentals Substitutes and Complements

24 Chapter 4Slide 24 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. e.g. gasoline and motor oil Substitutes and Complements

25 Chapter 4Slide 25 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

26 Chapter 4Slide 26 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. They could be both!

27 Chapter 4Slide 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.

28 Chapter 4Slide 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.

29 Chapter 4Slide 29 Income and Substitution Effects Substitution Effect The substitution effect is the change in an items 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.

30 Chapter 4Slide 30 Income and Substitution Effects Income Effect The income effect is the change in an items consumption brought about by the increase in purchasing power, with the price of the item held constant. When a persons income increases, the quantity demanded for the product may increase or decrease.

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

32 Chapter 4Slide 32 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 (satisfaction) constant.

33 Chapter 4Slide 33 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

34 Chapter 4Slide 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.

35 Chapter 4Slide 35 Effect of a Gasoline Tax With a Rebate Assume P e d = -0.5 Income = $9,000 Price of gasoline = $1

36 Chapter 4Slide 36 Effect of a Gasoline Tax With a Rebate Gasoline Consumption (gallons/year) Expenditures On Other Goods ($) A C Gasoline = 1200 gallons Other expenditures = $7800 U2U2 1200 Original Budget Line B D U1U1 900 After Gasoline Tax E $.50 Excise Tax Gasoline = 900 gallons J F H 913.5 After Gasoline Tax Plus Rebate U3U3 $450 REBATE New budget line Consumer is worse off

37 Chapter 4Slide 37 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

38 Chapter 4Slide 38 Determining the Market Demand Curve 16101632 2481325 3261018 404711 50246 PriceIndividual AIndividual BIndividual CMarket ($)(units)(units)(units)(units)

39 Chapter 4Slide 39 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 consumers demand curves

40 Chapter 4Slide 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.

41 Chapter 4Slide 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.

42 Chapter 4Slide 42 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

43 Chapter 4Slide 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.

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

45 Chapter 4Slide 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.

46 Chapter 4Slide 46 Market Demand 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: -2/6 = -33.33% or -2/4 = -50% Point Elasticity of Demand (An Example)

47 Chapter 4Slide 47 Market Demand Elasticity equals: -33.33/.25 = -1.33 or -.50/.20 = -2.54 Which one is correct? Point Elasticity of Demand (An Example)

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

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

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

51 Chapter 4Slide 51 The Aggregate Demand For Wheat The domestic demand for wheat is given by the equation: Q DD = 1700 - 107P The export demand for wheat is given by the equation: Q DE = 1544 - 176P

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

53 Chapter 4Slide 53 C D Export Demand A B Domestic Demand Total world demand is the horizontal sum of the domestic demand AB and export demand CD. F Total Demand E The Aggregate Demand For Wheat Wheat(million bushels/yr. ) Price ($/bushel) 0 2 4 6 8 10 12 14 16 18 20 1000200030004000

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

55 Chapter 4Slide 55 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

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

57 Chapter 4Slide 57 Demand Curve Consumer Surplus Actual Expenditure Consumer Surplus for the Market Demand Consumer Surplus Rock Concert Tickets Price ($ per ticket) 23456 13 01 14 15 16 17 18 19 20 Market Price

58 Chapter 4Slide 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

59 Chapter 4Slide 59 The Value of Clean Air Air is free in the sense that we dont pay to breathe it. The Clean Air Act was amended in 1970. Question: Were the benefits of cleaning up the air worth the costs? An Example :

60 Chapter 4Slide 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.

61 Chapter 4Slide 61 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 $1000 per part reduced. Valuing Cleaner Air 2000 100 1000 5 A NOX (pphm) Pollution Reduction Value ($ per pphm of reduction)

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

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

64 Chapter 4Slide 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.

65 Chapter 4Slide 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).

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

67 Chapter 4Slide 67 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.

68 Chapter 4Slide 68 Demand Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D 20 20406080 100 D 40 D 60 D 80 D 100 Pure Price Effect 48 Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48,000 $20 $30

69 Chapter 4Slide 69 Demand Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D 20 20406080 100 D 40 D 60 D 80 D 100 Pure Price Effect $20 48 Bandwagon Effect But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. $30

70 Chapter 4Slide 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.

71 Chapter 4Slide 71 Negative Network Externality: Snob Effect Quantity (thousands per month) Price ($ per unit) Demand 2 D2D2 $30,000 $15,000 14 Pure Price Effect Originally demand is D 2, when consumers think 2000 people have bought a good. 468 D4D4 D6D6 D8D8 However, if consumers think 4,000 people have bought the good, demand shifts from D 2 to D 6 and its snob value has been reduced.

72 Chapter 4Slide 72 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 and long lines at the ski lift. Price ($ per unit) D2D2 $30,000 $15,000 14 D4D4 D6D6 D8D8 Demand Pure Price Effect Snob Effect Net Effect

73 Chapter 4Slide 73 Network Externalities and the Demands for Computers and Fax Machines Examples of Positive Feedback Externalities Mainframe computers: 1954 - 1965 Microsoft Windows PC operating system Fax-machines and e-mail

74 Chapter 4Slide 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.

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

76 Chapter 4Slide 76 In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed. Empirical Estimation of Demand

77 Chapter 4Slide 77 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. Empirical Estimation of Demand

78 Chapter 4Slide 78 YearQuantity (Q)Price (P)Income(I) Demand Data for Raspberries 198842410 198972010 199081710 1991131717 1992161017 1993151517 1994191220 199520920 199622520

79 Chapter 4Slide 79 Assuming only price determines demand: Q = a - bP Q = 28.2 -1.00P Empirical Estimation of Demand

80 Chapter 4Slide 80 Estimating Demand Quantity Price 0510152025 15 10 5 25 20 d1d1 d2d2 d3d3 D D represents demand if only P determines demand and then from the data: Q=28.2-1.00P

81 Chapter 4Slide 81 Estimating Demand Quantity Price 0510152025 15 10 5 25 20 D d1d1 d2d2 d3d3 d 1, d 2, d 3 represent the demand for each income level. Including income in the demand equation: Q = a - bP + cI or Q = 8.08 -.49P +.81I Adjusting for changes in income

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

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

84 Chapter 4Slide 84 Using the Raspberry data: Price elasticity = -0.24 (Inelastic) Income elasticity = 1.46 Empirical Estimation of Demand Estimating Elasticities

85 Chapter 4Slide 85 Substitutes: b 2 is positive Complements: b 2 is negative Empirical Estimation of Demand Estimating Complements and Substitutes

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

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

88 Chapter 4Slide 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.

89 Chapter 4Slide 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.

90 Chapter 4Slide 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.

91 Chapter 4Slide 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.

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

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


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