From the optimal choice of a consumer to overall market demand Consumer demand From the optimal choice of a consumer to overall market demand

Consumer demand Up until now, we’ve examined how a single consumer chooses the best (most satisfying) bundle out of the set of affordable ones The next step is to derive the demand function for each good: What amount of each good is chosen for each level of its price? Then, we need to see how all the individual demand functions add up to the market demand for that good

Consumer demand Deriving consumer demand From individual to market demand Elasticities

Deriving consumer demand As we have seen, given a stable set of preferences, the amount of a good chosen in a bundle depends on : The price of the good The price of other goods The income of the agent The quantity demanded by the ith agent is therefore a function of these three variables

Deriving consumer demand The effects of a change of income on demand: The demand for normal goods increases when income increases Some goods are inferior : The demand for these goods decreases when income increases If one plots all the quantities demanded for each level of income, one gets the Engel curve

Deriving consumer demand  C Income expansion path Good 1  B A  Good 2

Deriving consumer demand Other goods E3 E1 E2 150 E’3 100 E’1 50 E’2 DVD Income Demand for DVDs Engel curve

Deriving consumer demand Engel curves Demand Demand Income Income Normal good Inferior good

Deriving consumer demand The effects of a change of price on demand Generally, because of the substitution effect, the demand for a good varies inversely with its price Some goods are Giffen goods : The demand for these goods varies in the same direction as price (income effect) If one plots all the quantities demanded for each level of price, one gets the Demand curve

Deriving consumer demand  C  B Good 1 Good 2  A Price expansion path

Deriving consumer demand Other goods E3 E1 E2 10 E’3 20 E’1 40 E’2 DVD Price of DVDs Demand for DVDs Demand curve

Deriving consumer demand A typical demand curve: Price1 If the price falls, the individual demands more of the good Demandof agent i

Deriving consumer demand IMPORTANT NOTE: The demand function depends on The price of the good The price of other goods The income of the agent The demand curve only shows a relation between demand and the price of the good So how do the other variables (income, the price of other goods) affect the demand curve?

Deriving consumer demand The effect of income changes on the demand curve Price1 If the income increases, the demand increases (at constant price) If the income falls, the demand falls (at constant price) Demandof agent i

Deriving consumer demand The effect of a change in another price on the demand curve... Price1 ... is ambiguous !! It depends on the relative size of the income and substitution effects (Of opposite directions here) This in turn depends on whether the 2 goods are substitutes or complements Demandof agent i

Consumer demand Deriving consumer demand From individual to market demand Elasticities

From individual to market demand Market demand is the aggregate quantity demanded at a given price level It is not the demand of a single individual, but that of all the agents in the economy The market demand for a good depends on the relative price of that good and the distribution of all the incomes in the economy

From individual to market demand A simple 2-agent example Price Agent 1’s demand Agent 2’s demand Market demand

From individual to market demand A Market demand curve Price1 If the price falls, the market demand for the good increases Market Demand

Consumer demand Deriving consumer demand From individual to market demand Elasticities

Elasticities The concept of an elasticity is central to microeconomic theory : Up until now, we have reasoned in qualitative terms. A demand curve is downward sloping It moves upwards if income increases If we want our theory to be useful in the real world, we need to quantify these concepts. How sensitive is demand to price /Income ? Is this the same for all goods ?

Elasticities An elasticity is a measure of this sensitivity It gives the % change in one variable following a % change in another variable Example : The price elasticity of demand A price elasticity of demand of -0.5: An increase in price of 1 % ⇒ fall in demand of 0.5 % An increase in price of 10 % ⇒ fall in demand of 5 %

Elasticities The percentage change of a function is defined as: This means that we can express the elasticity as: Slope of the demand function Price/Demand ratio

Price elasticity of a linear demand curve Elasticities Price elasticity of a linear demand curve Price Quantity Slope of the demand function Price/Demand ratio p ∂p ∂Qd Demand Qd

Elasticities The demand function has 3 variables: We now have measure of sensitivity for all these variables: The price of the good Price elasticity of demand (which you already know) The price of other goods Cross price elasticity of demand The income of the agent Income elasticity of demand

Elasticities The price elasticity of demand: Is negative in general An increase in price reduces the quantity demanded Is positive for Giffen goods Demand is price-elastic if the price elasticity is greater than 1 in magnitude 10 % increase in price ⇒ >10% fall in demand Demand is price-inelastic if the price elasticity is smaller than 1 in magnitude 10 % increase in price ⇒ <10% fall in demand

Elasticities The cross price elasticity of demand Measures the variation of the quantity demanded following an increase in the price of another good This gives information on whether the goods are substitutes or complements Example : what is the effect of the increase in fuel prices on the demand for Hummers ??

Elasticities The cross price elasticity of demand Is negative in for complement goods Example : ↑ price of fuel ⇒ ↓ demand for cars Is positive for substitute goods Example : ↑ price of coffee ⇒ ↑ demand for tea The magnitude of the elasticity gives information on the strength of the link A large magnitude (>1) means a strong complement / substitute link A small magnitude (<1) means a weak link A magnitude close to 0 means no link

Elasticities The income elasticity of demand measures the variation of the quantity demanded following an increase in income of agents Is negative in for inferior goods An increase in income reduces the quantity demanded Is positive for normal goods An increase in income increases the quantity demanded Is greater than one for “luxury” goods An increase in income increases the quantity demanded more than proportionately