Chapter 4 Individual and Market Demand

©2005 Pearson Education, Inc. Chapter 42 Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Network Externalities

©2005 Pearson Education, Inc. Chapter 43 Individual Demand Price Changes  The impact of a change in the price of food can be illustrated using indifference curves.  For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves

©2005 Pearson Education, Inc. Chapter 44 Effect of a Price Change Each price leads to different amounts of food purchased 5 U3U3 D 4 U2U2 B 1220 Assume: I = $20 P C = $2 P F = $2, $1, $0.50 Food (units per month) Clothing 6 A U1U1 4 10

©2005 Pearson Education, Inc. Chapter 45 Effect of a Price Change By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual From the previous example: Demand Schedule PQ $ $ $0.504

©2005 Pearson Education, Inc. Chapter 46 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 $ $1.00 $.50

©2005 Pearson Education, Inc. Chapter 47 Effect of a Price Change Food (units per month) Price of Food H E G $ $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

©2005 Pearson Education, Inc. Chapter 48 Individual Demand Income Changes  The impact of a change in the income can be illustrated using indifference curves.  Changing income, with prices fixed, causes consumer to change their market baskets.

©2005 Pearson Education, Inc. Chapter 49 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. 3 4 A U1U B U2U2 D 7 16 U3U3 Assume: P f = $1, P c = $2 I = $10, $20, $30

©2005 Pearson Education, Inc. Chapter 410 Individual Demand Income Changes  The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.

©2005 Pearson Education, Inc. Chapter 411 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.

©2005 Pearson Education, Inc. Chapter 412 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 consumer’s demand curve to the right as well. $ D1D1 E 10 D2D2 G 16 D3D3 H

©2005 Pearson Education, Inc. Chapter 413 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.

©2005 Pearson Education, Inc. Chapter 414 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.

©2005 Pearson Education, Inc. Chapter 415 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.

©2005 Pearson Education, Inc. Chapter 416 Engel Curves Food (units per month) Income ($ per month) Engel curves slope upward for normal goods.

©2005 Pearson Education, Inc. Chapter 417 Income and Substitution Effects A change in the price of a good has two effects:  Substitution Effect  Income Effect

©2005 Pearson Education, Inc. Chapter 418 Income and Substitution Effects Substitution Effect  Relative price of a good changes when price changes  Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive.

©2005 Pearson Education, Inc. Chapter 419 Income and Substitution Effects Income Effect  Consumers experience an increase in real purchasing power when the price of one good falls.

©2005 Pearson Education, Inc. Chapter 420 Income and Substitution Effects Substitution Effect  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 demanded of the good.

©2005 Pearson Education, Inc. Chapter 421 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.

©2005 Pearson Education, Inc. Chapter 422 Income and Substitution Effects Income Effect  Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

©2005 Pearson Education, Inc. Chapter 423 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.

©2005 Pearson Education, Inc. Chapter 424 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

©2005 Pearson Education, Inc. Chapter 425 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.

©2005 Pearson Education, Inc. Chapter 426 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.  The sum of all the individual demand curves in the market

©2005 Pearson Education, Inc. Chapter 427 Determining the Market Demand Curve PriceABC Market Demand

©2005 Pearson Education, Inc. Chapter 428 Summing to Obtain a Market Demand Curve Quantity Price DBDB DCDC Market Demand DADA The market demand curve is obtained by summing the consumer’s demand curves

©2005 Pearson Education, Inc. Chapter 429 Market Demand From this analysis one can see two important points  The market demand will shift to the right as more consumers enter the market.  Factors that influence the demands of many consumers will also affect the market demand.

©2005 Pearson Education, Inc. Chapter 430 Consumer Surplus Consumers buy goods because it makes them better off Consumer Surplus measures how much better off they are

©2005 Pearson Education, Inc. Chapter 431 Consumer Surplus  The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid.  Can calculate consumer surplus from the demand curve

©2005 Pearson Education, Inc. Chapter 432 Consumer Surplus - Example Student wants to buy concert tickets Demand curve tells us willingness to pay for each concert ticket  1 st ticket worth $20 but price is $14 so student generates $6 worth of surplus  Can measure this for each ticket  Total surplus is addition of surplus for each ticket purchased

©2005 Pearson Education, Inc. Chapter 433 The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Consumer Surplus = 21 Consumer Surplus - Example Rock Concert Tickets Price ($ per ticket) Market Price Will not buy more than 7 because surplus is negative

©2005 Pearson Education, Inc. Chapter 434 Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller. Consumer surplus is area under the demand curve and above the price

©2005 Pearson Education, Inc. Chapter 435 Demand Curve Consumer Surplus Consumer Surplus for the Market Demand Consumer Surplus Rock Concert Tickets Price ($ per ticket) Actual Expenditure Market Price CS = ½ ($20 - $14)*(1600) = $19,500

©2005 Pearson Education, Inc. Chapter 436 Network Externalities Up to this point we have assumed that people’s demands for a good are independent of one another. For some goods, one person’s demand also depends on the demands of other people

©2005 Pearson Education, Inc. Chapter 437 Network Externalities If this is the case, a network externality exists. Network externalities can be positive or negative.

©2005 Pearson Education, Inc. Chapter 438 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.

©2005 Pearson Education, Inc. Chapter 439 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).  Positive network externality in which a consumer wishes to possess a good in part because others do

©2005 Pearson Education, Inc. Chapter 440 Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D When consumers believe more people have purchased the product, the demand curve shifts further to the the right. 40 D D D D 100

©2005 Pearson Education, Inc. Chapter 441 Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic. 40 D D D D 100 Demand

©2005 Pearson Education, Inc. Chapter 442 Positive Network Externality: Bandwagon Effect Quantity (thousands per month) Price ($ per unit) D Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48, D D D D 100 Demand But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. $30 48 $20 Pure Price Effect Bandwagon Effect

©2005 Pearson Education, Inc. Chapter 443 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.

©2005 Pearson Education, Inc. Chapter 444 Network Externality: Snob Effect Quantity (thousands per month) Price ($ per unit) 2 Demand D2D2 $30,000 $15, 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. Pure Price Effect

©2005 Pearson Education, Inc. Chapter 445 Network Externality: Snob Effect Quantity (thousands per month) Price ($ per unit) 2 Demand D2D2 $30,000 $15, D4D4 D6D6 D8D8 Pure Price Effect 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. Net Effect Snob Effect