1. Lecture 4Slide 1 Topics to be Discussed Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Empirical Estimation of Demand

2. Lecture 4Slide 2 Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2U2 U3U3 A B D U1U1 41220 Three separate indifference curves are tangent to each budget line. Assume: I = $20 P C = $2 P F = $2, $1, $.50 10

3. Lecture 4Slide 3 Price-Consumption Curve Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2U2 U3U3 A B D U1U1 41220 The price-consumption curve traces out the utility maximizing market basket for the various prices for food.

4. Lecture 4Slide 4 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 $2.00 41220 $1.00 $.50

5. Lecture 4Slide 5 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. Income-Consumption Curve 3 4 A U1U1 5 10 B U2U2 D 7 16 U3U3 Assume: P f = $1 P c = $2 I = $10, $20, $30

6. Lecture 4Slide 6 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. $1.00 4 D1D1 E 10 D2D2 G 16 D3D3 H

7. Lecture 4Slide 7 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. Normal Good vs. Inferior Good

8. Lecture 4Slide 8 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. Normal Good vs. Inferior Good

9. Lecture 4Slide 9 An Inferior Good Hamburger (units per month) Steak (units per month) 15 30 U3U3 C Income-Consumption Curve …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. 10520 5 10 A U1U1 B U2U2 Both hamburger and steak behave as a normal good, between A and B...

10. Consumer Expenditures in the United States Entertainment70094712741514205426544300 Owned Dwellings1116172522533243445457939898 Rented Dwellings1957217023712536213715401266 Health Care1031169719181820205222142642 Food2656338541094888542962208279 Clothing85997813631772177826143442 ExpenditureLess than1,000-20,000-30,000-40,000-50,000-70,000- ($) on:$10,00019,00029,00039,00049,00069,000and above Income Group (1997 $)

11. Lecture 4Slide 11 Individual Demand 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 Substitutes and Complements

12. Lecture 4Slide 12 Individual Demand 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 Substitutes and Complements

13. Lecture 4Slide 13 Individual Demand 3) Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other Substitutes and Complements

14. Lecture 4Slide 14 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.

15. Lecture 4Slide 15 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.

16. Lecture 4Slide 16 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 of the item demanded.

17. Lecture 4Slide 17 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.

18. Lecture 4Slide 18 Income and Substitution Effects Income Effect Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

19. Lecture 4Slide 19 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.

20. Lecture 4Slide 20 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

21. Lecture 4Slide 21 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.

22. Lecture 4Slide 22 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. From Individual to Market Demand

23. Lecture 4Slide 23 Determining the Market Demand Curve 16101632 2481325 3261018 404711 50246 PriceIndividual AIndividual BIndividual CMarket ($)(units)(units)(units)(units)

24. Lecture 4Slide 24 Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 51015202530 DBDB DCDC Market Demand DADA The market demand curve is obtained by summing the consumer’s demand curves

25. Lecture 4Slide 25 Market Demand Point Elasticity of Demand Point elasticity measures elasticity at a point on the demand curve. Its formula is:

26. Lecture 4Slide 26 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.

27. Lecture 4Slide 27 Market Demand 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: -2/6 = -33.33% or -2/4 = -50% Point Elasticity of Demand (An Example)

28. Lecture 4Slide 28 Market Demand Elasticity equals: -33.33/.25 = -1.33 or -.50/.20 = -2.54 Which one is correct? Point Elasticity of Demand (An Example)

29. Lecture 4Slide 29 Market Demand Arc Elasticity of Demand Arc elasticity calculates elasticity over a range of prices Its formula is:

30. Lecture 4Slide 30 Market Demand Arc Elasticity of Demand (An Example)

31. Lecture 4Slide 31 The Aggregate Demand For Wheat The demand for U.S. wheat is comprised of domestic demand and export demand. An Example:

32. Lecture 4Slide 32 The Aggregate Demand For Wheat The domestic demand for wheat is given by the equation: Q DD = 1700 - 107P The export demand for wheat is given by the equation: Q DE = 1544 - 176P

33. Lecture 4Slide 33 The Aggregate Demand For Wheat Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4).

34. Lecture 4Slide 34 C D Export Demand A B Domestic Demand Total world demand is the horizontal sum of the domestic demand AB and export demand CD. F Total Demand E The Aggregate Demand For Wheat Wheat(million bushels/yr. ) Price ($/bushel) 0 2 4 6 8 10 12 14 16 18 20 1000200030004000

35. Lecture 4Slide 35 Consumer Surplus The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid.

36. Lecture 4Slide 36 The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 Consumer Surplus Rock Concert Tickets Price ($ per ticket) 23456 13 01 14 15 16 17 18 19 20 Market Price

37. Lecture 4Slide 37 Demand Curve Consumer Surplus Actual Expenditure Consumer Surplus for the Market Demand Consumer Surplus Rock Concert Tickets Price ($ per ticket) 23456 13 01 14 15 16 17 18 19 20 Market Price

38. Lecture 4Slide 38 Consumer Surplus Combining consumer surplus with the aggregate profits that producers obtain we can evaluate: 1) Costs and benefits of different market structures 2)Public policies that alter the behavior of consumers and firms

39. Lecture 4Slide 39 The Value of Clean Air Air is free in the sense that we don’t pay to breathe it. The Clean Air Act was amended in 1970. Question: Were the benefits of cleaning up the air worth the costs? An Example :

40. Lecture 4Slide 40 The Value of Clean Air People pay more to buy houses where the air is clean. Data for house prices among neighborhoods of Boston and Los Angeles were compared with the various air pollutants.

41. Lecture 4Slide 41 The shaded area gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrous oxide at a cost of $1000 per part reduced. Valuing Cleaner Air 2000 100 1000 5 A NOX (pphm) Pollution Reduction Value ($ per pphm of reduction)

42. Lecture 4Slide 42 Empirical Estimation of Demand The most direct way to obtain information about demand is through interviews where consumers are asked how much of a product they would be willing to buy at a given price. Problem. Consumers may lack information or interest, or be mislead by the interviewer.

43. Lecture 4Slide 43 In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed. Empirical Estimation of Demand

44. Lecture 4Slide 44 The Statistical Approach to Demand Estimation 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. Empirical Estimation of Demand

45. Lecture 4Slide 45 YearQuantity (Q)Price (P)Income(I) Demand Data for Raspberries 198842410 198972010 199081710 1991131717 1992161017 1993151517 1994191220 199520920 199622520

46. Lecture 4Slide 46 Estimating Demand Quantity Price 0510152025 15 10 5 25 20 d1d1 d2d2 d3d3 D D represents demand if only P determines demand and then from the data: Q=28.2-1.00P

47. Lecture 4Slide 47 Estimating Demand Quantity Price 0510152025 15 10 5 25 20 D d1d1 d2d2 d3d3 d 1, d 2, d 3 represent the demand for each income level. Including income in the demand equation: Q = a - bP + cI or Q = 8.08 -.49P +.81I Adjusting for changes in income

48. Lecture 4Slide 48 Assuming: Price & income elasticity are constant The isoelastic demand = The slope, -b = price elasticity of demand Constant, c = income elasticity Empirical Estimation of Demand Estimating Elasticities

49. Lecture 4Slide 49 Using the Raspberry data: Price elasticity = -0.24 (Inelastic) Income elasticity = 1.46 Empirical Estimation of Demand Estimating Elasticities

50. Lecture 4Slide 50 Substitutes: b 2 is positive Complements: b 2 is negative Empirical Estimation of Demand Estimating Complements and Substitutes

51. Lecture 4Slide 51 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.

52. Lecture 4Slide 52 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 market demand curve is the horizontal summation of the individual demand curves for all consumers.