Individual and

1
Chapter 4

• Individual and
• Market Demand

2
Topics to be Discussed

• Individual Demand
• Income and Substitution Effects
• Market Demand
• Consumer Surplus

3
Topics to be Discussed

• Network Externalities
• Empirical Estimation of Demand

4
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.

5
Effect of a Price Change
Clothing (units per month)
Food (units per month)
6
Effect of a Price Change
The price-consumption curve traces out
the utility maximizing market basket for
the various prices for food.
Clothing (units per month)
6
A
Price-Consumption Curve
U1
D
5
B
4
U3
U2
Food (units per month)
4
12
20
7
Effect of a Price Change
Price of Food
Food (units per month)
8
Individual Demand
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.

9
Individual Demand
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.

10
Effect of a Price Change
Price of Food
Food (units per month)
11
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.

12
Effects of Income Changes
Clothing (units per month)
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.
Food (units per month)
13
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.
Food (units per month)
14
Individual Demand

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

15
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.

16
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.

17
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.

18
An Inferior Good
Steak (units per month)
Hamburger (units per month)
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.

20
Engel Curves
Income ( per month)
30
20
10
Food (units per month)
4
8
12
16
0
21
Engel Curves
Income ( per month)
30
20
10
Food (units per month)
4
8
12
16
0
22
Consumer Expendituresin the United States
Income Group (1997 )
Expenditure Less than 1,000- 20,000- 30,000- 40,00
0- 50,000- 70,000- () on 10,000 19,000 29,000 3
9,000 49,000 69,000 and above

• Entertainment 700 947 1274 1514 2054 2654 4300
• Owned Dwellings 1116 1725 2253 3243 4454 5793 9898
  
• Rented Dwellings 1957 2170 2371 2536 2137 1540 126
  6
• Health Care 1031 1697 1918 1820 2052 2214 2642
• Food 2656 3385 4109 4888 5429 6220 8279
• Clothing 859 978 1363 1772 1778 2614 3442

23
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

24
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

25
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

26
Individual Demand

• Substitutes and 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 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.

28
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.

29
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 of the item demanded.

30
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.

31
Income and Substitution Effects

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

32
Income and SubstitutionEffects Normal Good
Clothing (units per month)
Food (units per month)
O
33
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
34
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.

35
Effect of a Gasoline Tax With a Rebate

• Assume
• Ped -0.5
• Income 9,000
• Price of gasoline 1

36
Effect of a Gasoline Tax With a Rebate
Expenditures On Other Goods ()
Gasoline Consumption (gallons/year)
37
Market Demand
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.

38
Determining the Market Demand Curve
Price Individual A Individual B Individual
C Market () (units) (units) (units) (units)

• 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

39
Summing to Obtain aMarket Demand Curve
Price
5
4
3
2
1
Quantity
0
5
10
15
20
25
30
40
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.

41
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.

42
Price Elasticity andConsumer Expenditure

• Demand If Price Increases, If Price Decreases,
• Expenditures Expenditures

Inelastic (Ep lt1) Increase Decrease Unit Elastic
(Ep 1) Are unchanged Are unchanged Elastic (Ep
gt1) Decrease Increase
43
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.

44
Market Demand

• Point Elasticity of Demand
• Point elasticity measures elasticity at a point
  on the demand curve.
• Its formula is

45
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.

46
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
  -2/6 -33.33 or -2/4 -50

47
Market Demand
Point Elasticity of Demand (An Example)

• Elasticity equals
• -33.33/.25 -1.33 or -.50/.20 -2.54
• Which one is correct?

48
Market Demand

• Arc Elasticity of Demand
• Arc elasticity calculates elasticity over a range
  of prices
• Its formula is

49
Market Demand

• Arc Elasticity of Demand (An Example)

50
The Aggregate Demand For Wheat
An Example

• The demand for U.S. wheat is comprised of
  domestic demand and export demand.

51
The Aggregate Demand For Wheat

• The domestic demand for wheat is given by the
  equation
• QDD 1700 - 107P
• The export demand for wheat is given by the
  equation
• QDE 1544 - 176P

52
The Aggregate Demand For Wheat

• Domestic demand is relatively price inelastic
  (-0.2), while export demand is more price elastic
  (-0.4).

53
The Aggregate Demand For Wheat
Price (/bushel)
20
18
16
14
12
10
8
6
4
2
Wheat(million bushels/yr.)
0
1000
2000
3000
4000
54
Consumer Surplus

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

55
Consumer Surplus
Price ( per ticket)
20
19
18
17
16
Consumer Surplus 6 5 4
3 2 1 21
15
14
13
Rock Concert Tickets
2
3
4
5
6
0
1
56
Consumer Surplus

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

57
Consumer Surplus
Price ( per ticket)
Consumer Surplus for the Market Demand
20
19
18
17
16
15
14
13
Rock Concert Tickets
2
3
4
5
6
0
1
58
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

59
The Value of Clean Air
An Example

• 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?

60
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.

61
Valuing Cleaner Air
62
Network Externalities

• Up to this point we have assumed that peoples
  demands for a good are independent of one
  another.
• If fact, a persons demand may be affected by the
  number of other people who have purchased the
  good.

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).

66
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
Quantity (thousands per month)
67
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
D20
D40
D60
D80
D100
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)
20
40
60
80
100
68
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
D20
D40
D60
D80
D100
Suppose the price falls from 30 to 20. If there
were no bandwagon effect, quantity demanded
would only increase to 48,000
30
Demand
20
Pure Price Effect
Quantity (thousands per month)
20
40
60
80
100
48
69
Positive NetworkExternality Bandwagon Effect
Price ( per unit)
D20
D40
D60
D80
D100
But as more people buy the good, it becomes
stylish to own it and the quantity
demanded increases further.
30
Demand
20
Pure Price Effect
Bandwagon Effect
Quantity (thousands per month)
48
20
40
60
80
100
70
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.

71
Negative NetworkExternality Snob Effect
Price ( per unit)
Quantity (thousands per month)
72
Negative NetworkExternality Snob Effect
Price ( per unit)
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.
Demand
30,000
Net Effect
Snob Effect
15,000
D2
D4
D6
D8
Quantity (thousands per month)
2
4
6
8
14
Pure Price Effect
73
Network Externalities and the Demands for
Computers and Fax Machines

• Examples of Positive Feedback Externalities
• Mainframe computers 1954 - 1965
• Microsoft Windows PC operating system
• Fax-machines and e-mail

74
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.

75
Empirical Estimation of Demand

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

76
Empirical Estimation of Demand

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

77
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.

78
Demand Data for Raspberries

• Year Quantity (Q) Price (P) Income(I)

1988 4 24 10 1989 7 20 10 1990 8 17 10 1991 13 17
17 1992 16 10 17 1993 15 15 17 1994 19 12 20 1995
20 9 20 1996 22 5 20
79
Empirical Estimation of Demand

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

80
Estimating Demand
Price
25
20
15
10
5
Quantity
0
5
10
15
20
25
81
Estimating Demand
Adjusting for changes in income
82
Empirical Estimation of Demand
Estimating Elasticities

• For the demand equation Q a - bP
• Elasticity

83
Empirical Estimation of Demand
Estimating Elasticities

• Assuming Price income elasticity are constant
• The isoelastic demand
• The slope, -b price elasticity of demand
• Constant, c income elasticity

84
Empirical Estimation of Demand
Estimating Elasticities

• Using the Raspberry data
• Price elasticity -0.24 (Inelastic)
• Income elasticity 1.46

85
Empirical Estimation of Demand
Estimating Complements and Substitutes

• Substitutes b2 is positive
• Complements b2 is negative

86
The Demand for Ready-to-Eat Cereal

• What Do You Think?
• Are Grape Nuts Spoon Size Shredded Wheat good
  substitutes?

87
The Demand for Ready-to-Eat Cereal

• Answer
• Estimated demand for Grape Nuts (GN)
• Price elasticity -2.0
• Income elasticity 0.62
• Cross elasticity 0.14

88
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.

89
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.

90
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.

91
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.

92
Summary

• There is a network externality when one persons
  demand is affected directly by the purchasing
  decisions of other consumers.
• A number of methods can be used to obtain
  information about consumer demand.

93
End of Chapter 4

• Individual and
• Market Demand