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
Individual Demand

• The Demand Curve
• The price-consumption curve traces the
  utility-maximizing combinations of food and
  clothing associated with each and every price of
  food.
• The demand curve relates the quantity of food
  that the consumer will buy to the price of food.

6
Effect of a Price Change
Clothing (units per month)
Food (units per month)
7
Effect of a Price Change
Clothing (units per month)
The budget lines illustrate three prices for
food--2
2
Food (units per month)
8
Effect of a Price Change
Clothing (units per month)
The budget lines illustrate three prices for
food--2, 1,
2
1
Food (units per month)
9
Effect of a Price Change
Clothing (units per month)
The budget lines illustrate three prices for
food--2, 1, and .50
2
1
0.50
Food (units per month)
10
Effect of a Price Change
Clothing (units per month)
Three separate indifference curves are tangent
to each budget line.
A
U1
D
B
U3
U2
Food (units per month)
11
Effect of a Price Change
Clothing (units per month)
Three separate indifference curves are tangent
to each budget line.
6
A
U1
D
5
B
4
U3
U2
Food (units per month)
4
12
20
12
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
13
Effect of a Price Change
Price of Food
The points E, G, and H correspond to points A, B,
and D, respectively.
E
2.00
1.50
G
1.00
Demand Curve
.50
H
Food (units per month)
4
12
20
14
Individual Demand

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

15
Individual Demand

• 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.

16
Individual Demand

• Income 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.

17
Effects of Income Changes
Clothing (units per month)
7
5
3
Food (units per month)
4
10
16
18
Effects of Income Changes
Clothing (units per month)
An increase in income, with the prices
fixed, causes consumers to alter their choice
of market basket.
7
5
3
U1
A
Food (units per month)
4
10
16
19
Effects of Income Changes
Clothing (units per month)
An increase in income, with the prices
fixed, causes consumers to alter their choice
of market basket.
7
5
U2
B
3
U1
A
Food (units per month)
4
10
16
20
Effects of Income Changes
Clothing (units per month)
An increase in income, with the prices
fixed, causes consumers to alter their choice
of market basket.
7
D
U3
5
U2
B
3
U1
A
Food (units per month)
4
10
16
21
Effects of Income Changes
Clothing (units per month)
An increase in income, with the prices
fixed, causes consumers to alter their choice
of market basket.
Income-Consumption Curve
7
D
U3
5
U2
B
3
U1
A
Food (units per month)
4
10
16
22
Effects of Income Changes
Price of food
An increase in income, with the prices
fixed, shifts the consumers demand curve to the
right. Points E, G and H correspond to A, B,
and D on the previous graph respectively.
E
1.00
D1
Food (units per month)
4
10
16
23
Effects of Income Changes
Price of food
An increase in income, with the prices
fixed, shifts the consumers demand curve to the
right. Points E, G and H correspond to A, B,
and D on the previous graph respectively.
E
G
1.00
D2
D1
Food (units per month)
4
10
16
24
Effects of Income Changes
Price of food
An increase in income, with the prices
fixed, shifts the consumers demand curve to the
right. Points E, G and H correspond to A, B,
and D on the previous graph respectively.
E
G
H
1.00
D3
D2
D1
Food (units per month)
4
10
16
25
Individual Demand

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

26
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.

27
Individual Demand

• Income Changes
• If the income-consumption curve has a positive
  slope, the quantity demanded increases with
  income and the income elasticity of demand is
  positive.
• The good is a normal good.

28
Individual Demand

• Income Changes
• If the income-consumption curve has a negative
  slope, the quantity demanded decreases with
  income and the income elasticity of demand is
  negative.
• The good is an inferior good.

29
An Inferior Good
15
Steak (units per month)
10
5
Hamburger (units per month)
5
10
20
30
30
An Inferior Good
15
Steak (units per month)
10
5
A
U1
Hamburger (units per month)
5
10
20
30
31
An Inferior Good
15
Steak (units per month)
Both hamburger and steak behave as a normal good,
between A and B...
10
B
5
U2
A
U1
Hamburger (units per month)
5
10
20
30
32
An Inferior Good
15
Steak (units per month)
but hamburger becomes and inferior good when the
income consumption curve bends backward between
B and C.
C
10
U3
B
5
U2
A
U1
Hamburger (units per month)
5
10
20
30
33
An Inferior Good
15
Steak (units per month)
Income-Consumption Curve
but hamburger becomes and inferior good when the
income consumption curve bends backward between
B and C.
C
10
U3
B
5
B
U2
A
U1
Hamburger (units per month)
5
10
20
30
34
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.

35
Engel Curves
Income ( per month)
30
20
10
Food (units per month)
4
8
12
16
0
36
Engel Curves
Income ( per month)
30
Engel curves slope upward for normal goods.
20
10
Food (units per month)
4
8
12
16
0
37
Engel Curves
Income ( per month)
30
20
10
Hamburger (units per month)
5
10
0
38
Engel Curves
Income ( per month)
30
Engel curves slope backward bending for inferior
goods.
20
10
Hamburger (units per month)
5
10
0
39
Engel Curves
Income ( per month)
30
Inferior
Engel curves slope backward bending for inferior
goods.
20
Normal
10
Hamburger (units per month)
5
10
0
40
Example Consume Expenditures in the United States
Income Group (1993 )
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 520 894 1,185 1,602 2,018 2,565 4,00
  7
• Owned Dwellings 854 1,370 2,122 3,314 4,450 5,616
  9,736
• Rented Dwellings 1,642 2,128 1,978 1,884 1,802 1,5
  14 748
• Health Care 1,034 1,647 1,732 1,881 2,012 2,054 2,
  703
• Food 2,461 3,198 3,971 4,706 5,556 6,273 8,137
• Clothing 867 1,068 1,394 1,778 2,215 2,316 3,668

41
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. Butter and margarine

42
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. CDs and CD players

43
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!

44
Income and Substitution Effects

• A fall in the price of a good has two effects.
• Consumers experience an increase in real
  purchasing power.
• They will tend to consume more of the good that
  has become relatively cheaper, and less of the
  good that is now relatively more expensive.

45
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.

46
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.
• It usually still increases

47
Income and Substitution Effects

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

48
Income and Substitution Effects--Normal Good
Clothing (units per month)
Originally, the consumer is at A on budget line
RS.
R
C1
A
U1
Food (units per month)
O
F1
S
49
Income and Substitution Effects--Normal Good
Clothing (units per month)
When the price of food falls, consumption
increases by F1Fs as the consumer moves to B.
R
C1
A
B
C2
U2
U1
Food (units per month)
O
F1
S
F2
T
50
Income and Substitution Effects--Normal Good
Clothing (units per month)
The substitution effect,F1E, (from points AD),
changes the relative prices but keeps real
income constant.
R
C1
A
D
B
C2
U2
Substitution Effect
U1
Food (units per month)
O
F1
S
F2
T
E
Total Effect
51
Income and Substitution Effects--Normal Good
52
Income and Substitution Effects--Inferior Good
Clothing (units per month)
Originally, the consumer is at A on budget line
RS.
R
A
U1
Food (units per month)
O
F1
S
53
Income and Substitution Effects--Inferior Good
Clothing (units per month)
The substitution effect,F1E, (from points AD),
changes the relative prices but keeps real
income constant.
R
A
D
Substitution Effect
U1
Food (units per month)
O
F1
S
T
E
54
Income and Substitution Effects--Inferior Good
Since food is an inferior good, the income
effect is negative. However, the substitution
effect is larger than the income effect.
55
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.

56
Market Demand

• From Individual to Market Demand
• Market demand curves are the horizontal summation
  of the individuals demand curves.

57
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

58
Summing to Obtain aMarket Demand Curve
Price
5
The market demand curve is obtained by summing
the consumers demand curves
4
3
2
1
DA
0
5
10
15
20
25
30
Quantity
59
Summing to Obtain aMarket Demand Curve
Price
5
The market demand curve is obtained by summing
the consumers demand curves
4
3
2
1
DA
DB
0
5
10
15
20
25
30
Quantity
60
Summing to Obtain aMarket Demand Curve
Price
5
The market demand curve is obtained by summing
the consumers demand curves
4
3
2
1
DA
DB
DC
0
5
10
15
20
25
30
Quantity
61
Summing to Obtain aMarket Demand Curve
Price
5
The market demand curve is obtained by summing
the consumers demand curves
4
3
Market Demand
2
1
DA
DB
DC
0
5
10
15
20
25
30
Quantity
62
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.

63
Market Demand

• Point and Arc Elasticities of Demand
• Recall Price elasticity of demand measures the
  percentage change in the quantity demanded
  resulting from a percentage change in price.

64
Price Elasticity andConsumer Expenditure

• If Price Increases, If Price Decreases,
• Demand Expenditures Expenditures
• Inelastic (Eplt1) Increase Decrease
• Unit elastic (Ep1) Are unchanged Are unchanged
• Elastic (Epgt1) Decrease Increase

65
Market Demand

• Point and Arc Elasticities 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.

66
Market Demand

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

67
Market Demand

• Problems Using Point Elasticity
• We may need to calculate elasticity between two
  points instead of at a single point.
• The price and quantity used as the original will
  alter the price elasticity of demand.
• Using different original values will result in
  different calculations.

68
Market Demand

• Point and Arc Elasticities of Demand
• Arc Elasticity Arc elasticity uses the average
  of the initial and final price as the original.
• Its formula is

69
ExampleThe AggregateDemand For Wheat

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

70
ExampleThe AggregateDemand For Wheat

• The domestic demand for wheat is given by the
  equation
• QDD 1354 - 70P
• The export demand for wheat is given by the
  equation
• QDE 2031 - 209P

71
ExampleThe AggregateDemand For Wheat

• Domestic demand is relatively price inelastic
  (-0.2), while export demand is more price elastic
  (-0.4 to -0.5).

72
The Aggregate Demandfor Wheat
Price (/bushel)
20
A
18
16
14
12
C
10
8
6
Export Demand
4
Domestic Demand
2
B
D
0
1000
2000
3000
4000
Quantity (millions of bushels per year)
73
The Aggregate Demandfor Wheat
Price (/bushel)
Total world demand is the horizontal sum of the
domestic demand AB and export demand CD.
20
A
18
16
Total Demand
14
12
E
C
10
8
6
Export Demand
4
Domestic Demand
2
B
D
F
0
1000
2000
3000
4000
Quantity (millions of bushels per year)
74
Consumer Surplus

• Consumer surplus is the difference between what a
  consumer is willing to pay for a good and what
  the consumer actually pays when buying it.

75
Consumer Surplus
Price ( per ticket)
20
19
18
17
16
15
14
13
2
3
4
5
6
0
1
Rock Concert Tickets
76
Consumer Surplus
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
15
Market Price
14
13
2
3
4
5
6
0
1
Rock Concert Tickets
77
Consumer Surplus
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
15
Market Price
14
13
2
3
4
5
6
0
1
Rock Concert Tickets
78
Consumer Surplus
Price ( per ticket)
The consumers actual expenditure is the price
times the quantity purchased.
20
19
18
17
16
Consumer Surplus
15
Market Price
14
13
Actual Expenditure
2
3
4
5
6
0
1
Rock Concert Tickets
79
Consumer Surplus

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

80
Consumer Surplus
Price ( per ticket)
For goods that cannot be divided into small parts
the consumer surplus is the yellow area below the
demand curve.
20
19
18
17
16
Consumer Surplus
15
Market Price
14
13
Demand Curve
Actual Expenditure
2
3
4
5
6
0
1
Rock Concert Tickets
81
Consumer Surplus

• Consumer surplus along with aggregate profits
  allow us to evaluate
• 1) Costs and benefits of different market
  structures
• 2) Public policies that alter the behavior of
  consumers and firms

82
ExampleThe Value of Clean Air

• Air is free in the sense that we need not pay to
  breathe it.
• The Clean Air Act was amended in 1970.
• Question Were the benefits of cleaning up the
  air worth the costs?

83
ExampleThe 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.

84
Valuing Clean Air
Value ( per pphm of reduction)
2000
1000
NOX (pphm) Pollution Reduction
0
5
10
85
Valuing Clean Air
Value ( per pphm of reduction)
2000
1000
NOX (pphm) Pollution Reduction
0
5
10
86
Valuing Clean Air
Value ( per pphm of reduction)
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.
2000
A
1000
NOX (pphm) Pollution Reduction
0
5
10