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# Individual and Market Demand

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Individual and Market Demand
Chapter 4 Individual and Market Demand 1

Topics to be Discussed Individual Demand
Income and Substitution Effects Market Demand Consumer Surplus Network Externalities Empirical Estimation of Demand Chapter 4 2

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 figures developed in the previous chapter, the impact of a change in the 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

Individual Demand Income Changes
The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level. Chapter 4 4

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. Chapter 4 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 curves slope upward for normal goods. 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 curves slope backward bending for inferior goods. Inferior Normal 20 10 Food (units per month) 4 8 12 16 Chapter 4

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

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, thus increasing consumption. 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 F2 E S T 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) 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 Two Important Points
1) The market demand will shift to the right as more consumers enter the market. 2) Factors that influence the demands of many consumers will also affect the market demand. 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: /6 = % 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 = or -.50/.20 = -2.54 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 = 21 15 14 Market Price 13 1 2 3 4 5 6 Rock Concert Tickets Chapter 4

Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller. 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

Network Externalities
Up to this point we have assumed that people’s demands for a good are independent of one another. If fact, a person’s demand may be affected by the number of other people who have purchased the good. Chapter 4

Network Externalities
If this is the case, a network externality exists. Network externalities can be positive or negative. Chapter 4

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. Chapter 4

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). Chapter 4

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. Chapter 4

Empirical Estimation of Demand
The Statistical Approach to Demand Estimation Surveys Properly applied, the statistical approach to demand estimation can enable one to sort out the effects of variables on the quantity demanded of a product. “Least-squares” regression is one approach. Chapter 4

Summary Individual consumers’ demand curves for a commodity can be derived from information about their tastes for all goods and services and from their budget constraints. Engel curves describe the relationship between the quantity of a good consumed and income. Chapter 4

Summary Two goods are substitutes if an increase in the price of one good leads to an increase in the quantity demanded of the other. They are complements if the quantity demanded of the other declines. Chapter 4

Summary Two goods are substitutes if an increase in the price of one good leads to an increase in the quantity demanded of the other. They are complements if the quantity demanded of the other declines. The effect of a price change on the quantity demanded can be broken into a substitution effect and an income effect. Chapter 4

Summary The market demand curve is the horizontal summation of the individual demand curves for all consumers. The percent change in quantity demanded that results from a one percent change in price determines elasticity of demand. Chapter 4

Summary There is a network externality when one person’s demand is affected directly by the purchasing decisions of other consumers. A number of methods can be used to obtain information about consumer demand. Chapter 4

End of Chapter 4 1

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