MICROECONOMICS: Theory & Applications Chapter 4 Individual and Market Demand By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 9th Edition, copyright 2006 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Understand how price changes affect consumption choices. Differentiate between the income and substitution effects associated with a price change on the consumption of a particular good. Explain the relation between income and substitution effects in the case of inferior goods. Show how individual demand curves are aggregated to obtain the market demand curve. (continued) John Wiley & Sons, Inc. Copyright 2006

Learning Objectives (continued) Demonstrate how consumer surplus represents the net benefit , or gain, served by an individual from consuming one market basket instead of another. Investigate the relationship between own-price elasticity of demand and the price-consumption curve. Examine network effects: the extent to which an individual consumer’s demand for a good is influenced by other individuals’ purchases. Overview the basics of demand estimation. John Wiley & Sons, Inc. Copyright 2006

Price Changes and Consumption Choices Price-consumption curve: a curve that identifies the optimal market basket associated with each possible price of a good, holding constant all other determinants of demand. The consumer’s demand curve can be derived from the price-consumption curve. Figure 4.1 John Wiley & Sons, Inc. Copyright 2006

Some Remarks about the Demand Curve The consumer’s level of well-being varies along the demand curve. The prices of other goods are held constant among a demand curve, but the quantities purchased of these other goods can vary. At each point on the demand curve, the consumer’s optimality condition is satisfied: MRSXO = PX/PO where “O” refers to “other goods” (composite good). The demand curve identifies the marginal benefit associated with various levels of consumption. John Wiley & Sons, Inc. Copyright 2006

Do Demand Curves Always Slope Downward? [Figure 4.2] John Wiley & Sons, Inc. Copyright 2006

Income and Substitution Effects of a Price Change Income effect – a change in a consumer’s real purchasing power brought about by a change in the price of a good Substitution effect – an incentive to increase consumption of a good whose price falls, at the expense of other, now relatively more expensive, goods John Wiley & Sons, Inc. Copyright 2006

Income and Substitution Effects Illustrated: The Normal-Good Case [Figure 4.3] John Wiley & Sons, Inc. Copyright 2006

A Graphical Examination of a Tax-Plus-Rebate Program [Figure 4.4] John Wiley & Sons, Inc. Copyright 2006

Income and Substitution Effects Illustrated: Inferior Goods [Figure 4 John Wiley & Sons, Inc. Copyright 2006

Possibilities for Inferior Goods If the substitution effect is larger than the income effect, then the demand curve will have a negative slope. If the income effect is larger than the substitution effect, then the demand curve will have a positive slope. This type of inferior good is called a Giffen good. John Wiley & Sons, Inc. Copyright 2006

From Individual to Market Demand [Figure 4.6] John Wiley & Sons, Inc. Copyright 2006

Consumer Surplus Consumer surplus – the net benefit or gain from consuming one market basket instead of another Total benefit – the total value a consumer derives from a particular amount of a good and thus the maximum amount the consumer would be willing to pay for that amount of the good. Marginal benefit – the incremental value a consumer derives from consuming an additional unit of a good and thus the maximum amount the consumer would pay for that additional unit John Wiley & Sons, Inc. Copyright 2006

Calculating Consumer Surplus [Figure 4.8] John Wiley & Sons, Inc. Copyright 2006

Geometric Calculation of Consumer Surplus [Figure 4.9] John Wiley & Sons, Inc. Copyright 2006

Consumer Surplus and Indifference Curves [Figure 4.11] John Wiley & Sons, Inc. Copyright 2006

Price Elasticity and the Price-Consumption Curve [Figure 4.12] John Wiley & Sons, Inc. Copyright 2006

Network Effects Network effects – the extent to which an individual consumer’s demand for a good is influenced by other individuals’ purchases Bandwagon effect – a positive network effect Snob effect – a negative network effect John Wiley & Sons, Inc. Copyright 2006

The Bandwagon Effect It exists whenever the quantity of a good demanded by a particular consumer is greater the larger the number of other consumers purchasing the same good. The market demand is more elastic than the individual demand curves. Figure 4.13 John Wiley & Sons, Inc. Copyright 2006

The Snob Effect It occurs when a consumer is less willing to purchase a good the more widespread its usage. The market demand is more inelastic than the individual demand curves. Figure 4.14 John Wiley & Sons, Inc. Copyright 2006

The Basics of Demand Estimation Experimentation Limitations: difficult to allow only one factor to change, holding the other factors constant may be incorrect to apply the results obtained from the sample to the entire population Surveys Important to choose a representative sample Reliability is dependent on respondents’ truthfulness Regression analysis (econometrics) – a statistical method that allows one to estimate the sensitivity of the quantity demanded of a good to determinants such as price and income John Wiley & Sons, Inc. Copyright 2006

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