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Chapter 4

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

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Chapter 4

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  1. Chapter 4 Individual and Market Demand

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

  3. 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 • For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves Chapter 4

  4. 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 Chapter 4

  5. 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 Chapter 4

  6. 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: Chapter 4

  7. 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. Chapter 4

  8. 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 Chapter 4

  9. 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 Chapter 4

  10. 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 • Changing income, with prices fixed, causes consumers to change their market baskets Chapter 4

  11. 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. Chapter 4

  12. 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

  13. 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

  14. 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 Chapter 4

  15. 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) Chapter 4

  16. 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 Chapter 4

  17. 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 Chapter 4

  18. 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. Chapter 4

  19. 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

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

  21. 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. Chapter 4

  22. Annual US Household Consumer Expenditures Chapter 4

  23. 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 Chapter 4

  24. 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 Chapter 4

  25. Substitutes & Complements • If two goods are independent, then a change in the price of one good has no effect on the quantity demanded of the other • Ex: price of chicken and price of airplane tickets Chapter 4

  26. 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 Chapter 4

  27. Income and Substitution Effects • A change in the price of a good has two effects: • Substitution Effect • Income Effect Chapter 4

  28. 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 Chapter 4

  29. Income and Substitution Effects • Income Effect • Consumers experience an increase in real purchasing power when the price of one good falls Chapter 4

  30. 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 Chapter 4

  31. 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

  32. Income and Substitution Effects • Income Effect • Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect Chapter 4

  33. 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 Chapter 4

  34. 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 Chapter 4

  35. 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 Chapter 4

  36. 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 Chapter 4

  37. Determining the Market Demand Curve Chapter 4

  38. 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 Chapter 4

  39. 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 Chapter 4

  40. Market Demand • Aggregation is important to be able to discuss regarding demand for different groups • Households with children • Consumers aged 20 – 30, etc. Chapter 4

  41. Market Demand • Price Elasticity of Demand • Measures the percentage change in the quantity demanded resulting from a percent change in price Chapter 4

  42. Price Elasticity of Demand • Inelastic Demand • Ep is less than 1 in absolute value • Quantity demanded is relatively unresponsive to a change in price • |%Q| < |%P| • Total expenditure (P*Q) increases when price increases Chapter 4

  43. Price Elasticity of Demand • Elastic Demand • Ep is greater than than 1 in absolute value • Quantity demanded is relatively responsive to a change in price • |%Q| > |%P| • Total expenditure (P*Q) decreases when price increases Chapter 4

  44. Price Elasticity andConsumer Expenditure Chapter 4

  45. Price Elasticity of Demand • Isoelastic Demand • When price elasticity of demand is constant along the entire demand curve • Demand curve is bowed inward (not linear) Chapter 4

  46. The Aggregate Demand for Wheat • The demand for US wheat is comprised of two components: • Domestic demand • Export demand • Total demand for wheat can be obtained by aggregating these two demands Chapter 4

  47. The Aggregate Demand for Wheat • The domestic demand for wheat is given by the equation: • QDD = 1465 - 88P • The export demand for wheat is given by the equation: • QDE = 1344 - 138P Chapter 4

  48. The Aggregate Demand for Wheat • Domestic demand is relatively price inelastic (Ed = -0.2) • Export demand is more price elastic (Ed = -0.4) • Poorer countries that import US wheat turn to other grains and food if wheat prices increase Chapter 4

  49. A C E Total Demand Export Demand Domestic Demand F D B The Aggregate Demand for Wheat Price Total world demand is the horizontal sum of the domestic demand AB and export demand CD. 18 16 Above C, export demand is zero, so domestic demand = total demand = AE segment 10 Wheat 0 Chapter 4

  50. Consumer Surplus • Consumers buy goods because it makes them better off • Consumer Surplus measures how much better off they are Chapter 4

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