Individual and Market Demand

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

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

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
5
Effect of a Price Change
The Price-Consumption Curve traces out the
utility maximizing market basket for each price
of food
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

Demand Schedule Demand Schedule
P Q
2.00 4
1.00 12
0.50 20
7
Effect of a Price Change
Individual Demand relates the quantity of a good
that a consumer will buy to the price of that
good.
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

9
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
• HPf /Pc .5/2 .25 MRS

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

11
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.
12
Individual Demand

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

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

14
Effects of Income Changes
The Income Consumption Curve traces out the
utility maximizing market basket for each income
level
Income Consumption Curve
15
Effects of Income Changes
Price of food
An increase in income, from 10 to 20 to 30,
with the prices fixed, shifts the consumers
demand curve to the right as well.
Food (units per month)
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

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

18
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.
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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

20
Engel Curves
Engel curves slope upward for normal goods.
21
Engel Curves
Engel curves are backward bending for inferior
goods.
22
Annual US Household Consumer Expenditures
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

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

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

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

27
Income and Substitution Effects

• A change in the price of a good has two effects
• Substitution Effect
• Income Effect

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

29
Income and Substitution Effects

• Income Effect
• Consumers experience an increase in real
  purchasing power when the price of one good falls

30
Income and Substitution Effects

• Substitution Effect
• The substitution effect is the change in an
  items 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

31
Income and Substitution Effects

• Income Effect
• The income effect is the change in an items
  consumption brought about by the increase in
  purchasing power, with the price of the item held
  constant
• When a persons income increases, the quantity
  demanded for the product may increase or decrease

32
Income and Substitution Effects

• Income Effect
• Even with inferior goods, the income effect is
  rarely large enough to outweigh the substitution
  effect

33
Income and SubstitutionEffects Normal Good
Clothing (units per month)
Food (units per month)
O
34
Income and SubstitutionEffects Inferior Good
Clothing (units per month)
R
A
D
Substitution Effect
U1
Food (units per month)
O
F1
S
F2
T
E
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

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

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Determining the Market Demand Curve
Price A B C Market Demand
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
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Summing to Obtain aMarket Demand Curve
The market demand curve is obtained by summing
the consumers demand curves
Quantity
5
10
15
20
25
30
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

40
Market Demand

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

41
Market Demand

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

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 lt ?P
• Total expenditure (PQ) increases when price
  increases

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 gt ?P
• Total expenditure (PQ) decreases when price
  increases

44
Price Elasticity andConsumer Expenditure
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)

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

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

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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

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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
50
Consumer Surplus

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

51
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

52
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

53
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
2
3
4
5
6
0
1
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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 the area under the demand
  curve and above the price

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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
2
3
4
5
6
0
1
Rock Concert Tickets
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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

57
Applying Consumer Surplus An Example

• The Value of Clean Air
• Air is free in the sense that we dont pay to
  breathe it
• The Clean Air Act was amended in 1970
• Question Were the benefits of cleaning up the
  air worth the costs?

58
The Value of Clean Air

• Empirical data determined estimates for the
  demand for clean air
• No market exists for clean air, but can see
  people are willing to pay for it
• Ex People pay more to buy houses where the air
  is clean

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The Value of Cleaner Air

• Using these empirical estimates, we can measure
  peoples consumer surplus for pollution reduction
  from the demand curve

60
Valuing Cleaner Air
61
Value of Cleaner Air

• A full cost-benefit analysis would include total
  benefit of cleanup
• Total benefits would be compared to total costs
  to determine if the clean up was worthwhile

62
Network Externalities

• Up to this point we have assumed that peoples
  demands for a good are independent of one another
• For some goods, one persons demand also depends
  on the demands of other people

63
Network Externalities

• If this is the case, a network externality exists
• Network externalities can be positive or negative

64
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

65
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)
• Positive network externality in which a consumer
  wishes to possess a good in part because others do

66
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
When consumers believe more people have
purchased the product, the demand curve shifts
further to the the right.
Quantity (thousands per month)
67
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
The market demand curve is found by joining the
points on the individual demand curves. It is
relatively more elastic.
Demand
Quantity (thousands per month)
68
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
Suppose the price falls from 30 to 20. If there
were no bandwagon effect, quantity demanded
would only increase to 48,000
But as more people buy the good, it becomes
stylish to own it and the quantity
demanded increases further.
Demand
Quantity (thousands per month)
69
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

70
Network Externality Snob Effect
Price ( per unit)
Originally demand is D2, when consumers think
2,000 people have bought a good.
30,000
15,000
D2
Quantity (thousands per month)
2
14
71
Network Externality Snob Effect
The demand is less elastic and as a snob good
its value is greatly reduced if more people
own it. Sales decrease as a result. Examples
Rolex watches and long lines at the ski lift.
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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

73
Empirical Estimation of Demand

• Problem
• Consumers may lack information or interest, or be
  misled by the interviewer

74
Empirical Estimation of Demand

• In direct marketing experiments, actual sales
  offers are posed to potential customers and the
  responses of customers are observed

75
Empirical Estimation of Demand

• 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

76
Demand Data for Raspberries
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Empirical Estimation of Demand

• Assuming only price determines demand
• Q a - bP
• Q 28.2 -1.00P

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Estimating Demand
25
Price
20
15
10
5
Quantity
0
5
10
15
20
25
79
Estimating Demand Changes in Income
80
Empirical Estimation of Demand

• Estimating Elasticities
• For the demand equation Q a - bP
• Elasticity

81
Empirical Estimation of Demand

• Assuming Price and income elasticity are
  constant
• The isoelastic demand

The slope, -b price elasticity of
demand Constant, c income elasticity of demand
82
Empirical Estimation of Demand

• Using the Raspberry data

Price elasticity -0.24 (Inelastic) Income
elasticity 1.46
83
Empirical Estimation of Demand
Complements and Substitutes

• Substitutes b2 is positive
• Complements b2 is negative

84
The Demand for Ready-to-Eat Cereal

• Are Grape Nuts and Spoon Size Shredded Wheat good
  substitutes?
• Estimated demand for Grape Nuts (GN)

Price elasticity -2.0 Income elasticity
0.62 Cross elasticity 0.14