Individual and Market Demand Chapter 4 Individual and Market Demand 1

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

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

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

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

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

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

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

Individual Demand Income Changes Using the Food-Clothing example developed in chapter 3, the impact of a change in income can be illustrated using indifference curves. Chapter 4 4

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

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

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

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

An Inferior Good 15 30 Steak (units per month) 10 5 20 Hamburger C 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

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

Engel Curves 30 20 10 4 8 12 16 Income ($ per month) Food (units Engel curve slopes upward for a normal good. 30 20 10 Food (units per month) 4 8 12 16 Chapter 4

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

Consumer Expenditures in the United States Income Group (1997 $) Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above Entertainment 700 947 1274 1514 2054 2654 4300 Owned Dwellings 1116 1725 2253 3243 4454 5793 9898 Rented Dwellings 1957 2170 2371 2536 2137 1540 1266 Health Care 1031 1697 1918 1820 2052 2214 2642 Food 2656 3385 4109 4888 5429 6220 8279 Clothing 859 978 1363 1772 1778 2614 3442

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Determining the Market Demand Curve Price Individual A Individual B Individual C Market ($) (units) (units) (units) (units) 1 6 10 16 32 2 4 8 13 25 3 2 6 10 18 4 0 4 7 11 5 0 2 4 6 Chapter 4

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

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

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

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

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

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

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: -2/6 = -33.33% or -2/4 = -50% Chapter 4

Point Elasticity of Demand (An Example) Market Demand Point Elasticity of Demand (An Example) Elasticity equals: -33.33/25 = -1.33 or -50/20 = -2.5 Which one is correct? Chapter 4

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

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

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

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

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

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 1970. Question: Were the benefits of cleaning up the air worth the costs? Chapter 4

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

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