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Chapter 4

Chapter 4. Individual and Market Demand. Individual Demand. Price Changes The impact of a change in the price of good can be illustrated using indifference curves.

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Chapter 4

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  1. Chapter 4 Individual and Market Demand

  2. Individual Demand • Price Changes • The impact of a change in the price of good 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

  3. Clothing 10 6 A D 5 U1 B 4 U3 U2 Food (units per month) 12 20 4 Effect of a Price Change • Assume: • I = $20 • PC = $2 • PF = $2, $1, $0.50 Each price leads to different amounts of food purchased

  4. Clothing 10 6 A D 5 U1 B 4 U3 U2 Food (units per month) 12 20 4 Effect of a Price Change The Price-Consumption Curve traces out the utility maximizing market basket for each price of food

  5. 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:

  6. Price of Food E $2.00 Demand Curve G $1.00 $.50 H Food (units per month) 4 12 20 Effect of a Price Change Individual Demand relates the quantity of a good that a consumer will buy to the price of that good.

  7. Demand Curves – Important Properties • The level of utility that can be attained changes as we move along the curve. • 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.

  8. Price of Food E $2.00 G $1.00 $.50 H Food (units per month) 4 12 20 Demand Curve Effect of a Price Change When the price falls: Pf/Pc & MRS also fall • E: Pf/Pc = 2/2 = 1 = MRS • G: Pf/Pc = 1/2 = .5 = MRS • H:Pf/Pc = .5/2 = .25 = MRS

  9. 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.

  10. Clothing (units per month) 7 D U3 5 U2 B 3 U1 A Food (units per month) 4 10 16 Effects of Income Changes Assume: Pf = $1, Pc = $2 I = $10, $20, $30 An increase in income, with the prices fixed, causes consumers to alter their choice of market basket.

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

  12. 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.

  13. Clothing (units per month) 7 D U3 5 U2 B 3 U1 A Food (units per month) 4 10 16 Effects of Income Changes The Income Consumption Curve traces out the utility maximizing market basket for each income level Income Consumption Curve

  14. E G H $1.00 D3 D2 D1 4 10 16 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 as well. Food (units per month)

  15. 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.

  16. 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.

  17. Steak (units per month) C 10 U3 B 5 U2 A U1 Hamburger (units per month) 20 30 10 5 An Inferior Good Both hamburger and steak behave as a normal good, between A and B... Income-Consumption Curve …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C.

  18. 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.

  19. Income ($ per month) 30 20 10 Food (units per month) 4 8 12 16 Engel Curves Engel curves slope upward for normal goods.

  20. Income ($ per month) 30 Inferior 20 Normal 10 Food (units per month) 4 8 12 16 Engel Curves Engel curves are backward bending for inferior goods.

  21. Substitutes & Complements • 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. • Ex: movie tickets and video rentals

  22. Substitutes & Complements • 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. • Ex: gasoline and motor oil

  23. Substitutes & Complements • Two goods are independent then a change in the price of one good has no effect on the quantity demanded of the other • Ex: chicken and airplane tickets

  24. Substitutes & Complements • If the price consumption curve is downward-sloping, the two goods are considered substitutes. • If the price consumption curve is upward-sloping, the two goods are considered complements. • They could be both.

  25. Income and Substitution Effects • A change in the price of a good has two effects: • Substitution Effect • Income Effect

  26. 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.

  27. Income and Substitution Effects • Income Effect • Consumers experience an increase in real purchasing power when the price of one good falls.

  28. 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.

  29. 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.

  30. Income and Substitution Effects • Income Effect • Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

  31. When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. R The substitution effect,F1E, (from point A to D), changes the relative prices but keeps real income (satisfaction) constant. C1 A The income effect, EF2, ( from D to B) keeps relative prices constant but increases purchasing power. D B C2 U2 Substitution Effect U1 F1 E S F2 T Total Effect Income Effect Income and SubstitutionEffects: Normal Good Clothing (units per month) Food (units per month) O

  32. Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. B U2 Total Effect Income Effect Income and SubstitutionEffects: Inferior Good Clothing (units per month) R A D Substitution Effect U1 Food (units per month) O F1 E S F2 T

  33. 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.

  34. 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

  35. Determining the Market Demand Curve

  36. Price 5 4 3 Market Demand 2 1 DA DB DC 0 Summing to Obtain aMarket Demand Curve The market demand curve is obtained by summing the consumer’s demand curves Quantity 5 10 15 20 25 30

  37. 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.

  38. Market Demand • Aggregation is important to be able to discuss demand for different groups • Households with children • Consumers aged 20 – 30, etc.

  39. Market Demand • Price Elasticity of Demand • Measures the percentage change in the quantity demanded resulting from a percent change in price.

  40. Price Elasticity of Demand • Inelastic Demand • Ep is less than 1 in absolute value • Quantity demanded is relative unresponsive to a change in price • %Q < %P • Total expenditure (P*Q) increases when price increases

  41. Price Elasticity of Demand • Elastic Demand • Ep is greater than than 1 in absolute value • Quantity demanded is relative responsive to a change in price • %Q > %P • Total expenditure (P*Q) decreases when price increases

  42. Price Elasticity andConsumer Expenditure

  43. Consumer Surplus • Consumers buy goods because it makes them better off • Consumer Surplus measures how much better off they are

  44. Consumer Surplus • 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

  45. Consumer Surplus - Example • Student wants to buy concert tickets • Demand curve tells us willingness to pay for each concert ticket • 1st 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

  46. Market Price Consumer Surplus - Example 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 6 + 5 + 4 + 3 + 2 + 1 = 21 15 14 13 Will not buy more than 7 because surplus is negative Rock Concert Tickets 0 1 2 3 4 5 6

  47. 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

  48. Market Price Demand Curve Actual Expenditure Consumer Surplus Price ($ per ticket) Consumer Surplus for the Market Demand 20 19 CS = ½ ($20 - $14)*(1600) = $19,500 18 17 16 Consumer Surplus 15 14 13 0 1 2 3 4 5 6 Rock Concert Tickets

  49. Applying Consumer Surplus • Combining consumer surplus with the aggregate profits that producers obtain we can evaluate: • Costs and benefits of different market structures • Public policies that alter the behavior of consumers and firms

  50. Applying Consumer Surplus – An Example • 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?

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