1. Chapter 4

2. INDIVIDUAL AND MARKET DEMAND
Chapter 4
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Chapter Outline The Effects of Changes in the Price
The Effects of Changes in Income
The Income and Substitution Effects of a Price Change
Consumer Responsiveness to Changes in Price
Market Demand: Aggregating Individual Demand Curves
Price Elasticity of Demand
The Dependence of Market Demand on Income
Application: Forecasting Economic Trends
Cross-Price Elasticities of Demand

4. The Effect of Changes in Price
Price-consumption curve (PCC): for a good X is the set of optimal bundles traced on an indifference map as the price of X varies (holding income and the price of Y constant).

5. Figure 4.1: The Price-Consumption Curve
Y (R/wk)
1 200
1 000
800
600
400
360
300
200
(sq m/wk)

6. Figure 4.2: An Individual Consumer’s Demand Curve
Price (R/sq m)
240
200
150
120
100 60 50 40
Shelter (sq m/wk)

7. The Effects of Changes in Income
Income-consumption curve (ICC): for a good X is the set of optimal bundles traced on an indifference map as income varies (holding the prices of X and Y constant).
Engel curve: curve that plots the relationship between the optimal quantity of X consumed and income.

8. The Effects of Changes in Income
Normal good: one whose quantity demanded rises as income rises.
Inferior good: one whose quantity demanded falls as income rises.

9. Figure 4.3: An Income-Consumption Curve
The composite good (R/wk)
1 200
1 000
800
600
500
400
300
200
Shelter (sq m/wk)

10. Figure 4.4: An Individual Consumer’s Engel Curve
Income (R/wk)
1 200
1 000
800
600
400
200
Shelter(sq m/wk)

11. Figure 4.5: The Engel Curve for Normal and Inferior Goods
M (R/wk)
M (R/wk)
Maize porridge
(kg/wk)

12. Income and Substitution Effects
Substitution effect: that component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods.
Income effect: that component of the total effect of a price change that results from the associated change in real purchasing power.
Total effect: the sum of the substitution and income effects.

13. Figure 4.6: The Total Effect of a Price Increase
Y (R/wk)
1 200
700
600
Shelter (sq m/wk)

14. Figure 4.7: The Substitution and Income Effects of a Price Change for a Normal Good
Y (R/wk)
2400
1200
960
720
600
Shelter (sq m/wk)

15. Figure 4.8: Income and Substitution Effects for an Inferior Good
Y (R/wk)
340
240
180
160 60
Maize porridge
(kg/wk)

16. Giffen Goods
Giffen good: one for which the quantity demanded rises as its price rises.
The Giffen good is also an inferior good

17. Figure 4.9: The Demand Curve for a Giffen Good
Price of potatoes
(R/kg)
Potatoes (R/wk)

18. Figure 4.10: Income and Substitution Effects for Perfect Complements

19. Figure 4.11: Income and Substitution Effects for Perfect Substitutes

20. Figure 4.12: Income and Substitution Effects of a Price Increase for Salt
Y (R/mo)
Y (R/mo)
0.5
0.5002
Salt (kg/mo)
0.5001
Salt (kg/mo)

21. Figure 4.13: Income and Substitution Effects for a Price-Sensitive Good
Y (R/wk)
Y (R/wk)
72 000
60 000
Shelter (sq m/wk)

22. Figure 4.14: A Price Increase for Car Washes
Petrol (R/mo)
P = 40W
384
320
240
160 4 6 8 12

23. Figure 4.15: James’ Demand for Car Washes
Price (R/wash)
560
240 80

24. Market Demand Curves
Market demand curve: the horizontal summation of the individual demand curves.
Price elasticity of demand: the persentage change in the quantity of a good demanded that result from a 1 present change in its price.

25. Figure 4.16: Generating Market Demand from Individual Demands
Price (R/sq m)
Price (R/sq m)
Price (R/sq m)
1 600
1 600
1 600
1 400
1 400
1 400
1 200
1 200
1 200
1 000
1 000
1 000
800
800
800
600
600
600
400
400
400
200
200
200
Quantity (sq m/wk)
Quantity (sq m/wk)
Quantity (sq m/wk)

26. Figure 4.17: The Market Demand Curve for Beach Chairs
Price (R/chair)
Price (R/chair)
Price (R/chair)
300
300
300
Quantity (Chairs/wk)
Quantity (Chairs/wk)
Quantity (Chairs/wk)

27. Figure 4.18: Market Demand with Identical Consumers
Price (R/unit)

28. Three Categories of Price Elasticity
Inelastic → ε > -1
Unit elastic → ε = 1

29. Figure 4.19: Three Categories of Price Elasticity
Unit elastic
Unit elastic
Elastic
Inelastic
Inelastic
Elastic -3 -2 -1 1 2
(a) Normal calculated values
(b) Absolute values

30. Figure 4.20: The Point-Slope Method
Price (R/sq m)
1 600
1 400
PA =
1 200
€A = (PA /QA )(1/slope) = (1200/200)(-1/2) = -3
1 000
800
600
400
200
Quantity (sq m/wk)
400
600
800
1 000
2 000
200 = QA

31. Figure 4.21: Two Important Polar Cases

32. Figure 4.22: Elasticity is Unit-Free
P (R/l)
P (R/100g) 12
0,09375 9 0,
150
150
R/day
R/day

33. Elasticity and Total Revenue
A price reduction will increase total revenue if and only if the absolute value of the price elasticity of demand is greater than 1.
An increase in price will increase total revenue if and only if the absolute value of the price elasticity is less than 1.

34. Figure 4.23: The Effect on Total Expenditure of a Reduction in Price
Price (R/sq m)
1 600
1 400
1 200
1 000
800
600
400
200
Quantity (sq m/wk)
200
400
600
800
1 000
1 400
1 200
1 600

35. Figure 4.24: Demand and Total Expenditure

36. Figure 4.25: The Demand for Bus Rides
Price (R/ride)
10.00
7.50
5.00
2.50

37. Determinants of Price Elasticity of Demand
Substitution possibilities: the substitution effect of a price change tends to be small for goods with no close substitutes.
Budget share: the larger the share of total expenditures accounted for by the product, the more important will be the income effect of a price change.
Direction of income effect: a normal good will have a higher price elasticity than an inferior good.
Time: demand for a good will be more responsive to price in the long-run than in the short-run.

38. Figure 4.26: Effect of an energy tax with a rebate
Expenditure
on other goods (R)
After energy tax
Plus rebate F A
After energy
tax H C E U2 U1
Original budget
line
900
1 200 D J J
Electricity
Consumption (units per year)
913.5

39. Quantities (millions of
Figure 4.27: Price Elasticity Is Greater in the Long Run than in the Short Run
Price (R/litre)
PSR = 10.00
P LR = 8.50
7.50
Quantities (millions of
litres/day)

40. Figure 4.28: The Engel Curve for Food of A and B
Income (R/wk)
1 800
1 200
600
Food (kg/wk)

41. Figure 4.29: Market Demand Sometimes Depends on the Distribution of Income
Price (R/kg)
Price (R/kg)
Price (R/kg)
A’s food (kg/wk)
B’s food (kg/wk)
Food (kg/wk)

42. Figure 4.30: An Engel Curve at the Market Level
Average Income (R/wk)

43. Figure 4.31: Engel Curves for Different Types of Goods
Average Income (R/wk)
Average Income (R/wk)

44. Figure 4.32: Positive Network Externality: Bandwagon Effect
Demand
D20
D60
D40
D100
D80
Q (1000/pm)
P (R/unit) 40 60 80
100 20 48
200
Pure price effect
Bandwagon effect

45. Figure 4.33: : Negative Network Externality: Snob Effect
Demand D2 D6 D4 D8
Q (1000/pm)
P (R/unit) 4 6 8 14 2
Pure price effect
Snob effect
Net effect

46. Figure 4.34: A Constant Elasticity Demand Curve

47. Figure 4.35: The Segment-Ratio Method

48. Figure 4.36: Elasticity at Different Positions Along a Straight-Line Demand Curve

49. Figure 4.37: Intertemporal Consumption Bundles

50. Figure 4.38: The Intertemporal Budget Constraint
60 000
50 000

51. Figure 4.39: Intertemporal Budget Constraint with Income in Both Periods, and Borrowing or Lending at Rate r

52. Figure 4.40: An Intertemporal Indifference Map

53. Figure 4.41: The Optimal Intertemporal Allocation

54. Figure 4.42: Patience and Impatience

55. Figure 4.43: The Effect of a Rise in the Interest Rate