chapter 4 individual and market demand. topics to be discussed n individual demand n income and...
TRANSCRIPT
Chapter 4
Individual and
Market Demand
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Topics to be Discussed
Network Externalities
Empirical Estimation of Demand
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.
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.
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
The budget linesillustrate three
prices for food--$2
$2
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
The budget linesillustrate three
prices for food--$2, $1,
$2 $1
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
The budget linesillustrate three
prices for food--$2, $1,
and $.50
$2 $1 $0.50
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
A
U2
U3
BDU1
Three separateindifference curves
are tangent toeach budget line.
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
4
5
6
U2
U3
A
BDU1
4 12 20
Three separateindifference curves
are tangent toeach budget line.
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
4
5
6
U2
U3
Price-Consumption Curve
BD
A
U1
4 12 20
The price-consumptioncurve traces out theutility maximizing
market basket for thevarious prices for food.
Effect of a Price Change
Food (units per month)
Priceof Food
$2.00
$1.50
$1.00
$.50
4 12 20
Demand Curve
E
G
H
The points E, G, and Hcorrespond to points
A, B, and D,respectively.
Individual Demand
Two Important Properties of Demand Curves
1) The level of utility that can be attained changes as we move along the
curve.
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.
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.
Effects of Income Changes
Food (units per month)
3
7
4 10 16
5
Clothing(units per
month)
Effects of Income Changes
Food (units per month)
An increase in income,with the prices fixed,
causes consumers to altertheir choice ofmarket basket.
3
7
4 10 16
5
A U1
Clothing(units per
month)
Effects of Income Changes
Food (units per month)
An increase in income,with the prices fixed,
causes consumers to altertheir choice ofmarket basket.
3
7
4 10 16
5
A U1
BU2
Clothing(units per
month)
Effects of Income Changes
Food (units per month)
An increase in income,with the prices fixed,
causes consumers to altertheir choice ofmarket basket.
3
7
4 10 16
5
A U1
BU2
DU3
Clothing(units per
month)
Effects of Income Changes
Food (units per month)
Clothing(units per
month)
An increase in income,with the prices fixed,
causes consumers to altertheir choice ofmarket basket.
3
7
4 10 16
5
Income-Consumption Curve
A U1
BU2
DU3
Effects of Income Changes
Food (units per month)
Priceof
food
An increase in income,with the prices fixed,shifts the consumer’sdemand curve to the
right. Points E, G andH correspond to A, B, and D on the previous
graph respectively.$1.00
4 10 16
D1
E
Effects of Income Changes
Food (units per month)
Priceof
food
An increase in income,with the prices fixed,shifts the consumer’sdemand curve to the
right. Points E, G andH correspond to A, B, and D on the previous
graph respectively.$1.00
4 10 16
D1
D2
E G
Effects of Income Changes
Food (units per month)
Priceof
food
An increase in income,with the prices fixed,shifts the consumer’sdemand curve to the
right. Points E, G andH correspond to A, B, and D on the previous
graph respectively.$1.00
4 10 16
D1
D2
D3
E G H
Individual Demand
Income Changes
• The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.
Individual Demand
Income Changes
• An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.
• Simultaneously, the increase in income shifts the demand curve to the right.
Individual Demand
Income Changes
• If the income-consumption curve has a positive slope, the quantity demanded increases with income and the income elasticity of demand is positive.
• The good is a normal good.
Individual Demand
Income Changes
• If the income-consumption curve has a negative slope, the quantity demanded decreases with income and the income elasticity of demand is negative.
• The good is an inferior good.
An Inferior Good
Hamburger (units per month)
15
5 10 20
5
Steak(units per
month)
10
30
An Inferior Good
Hamburger (units per month)
15
5 10 20
5
Steak(units per
month)
10
30
AU1
An Inferior Good
Hamburger (units per month)
15
5 10 20
5
Steak(units per
month)
10
30
AU1
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
An Inferior Good
Hamburger (units per month)
15
5 10 20
5
Steak(units per
month)
10
30
AU1
B
U2
U3
C
…but hamburgerbecomes and inferiorgood when the income
consumption curvebends backward between B and C.
An Inferior Good
Hamburger (units per month)
15
5 10 20
5
Steak(units per
month)
10
30
A
B
U1
B
U2
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes and inferiorgood when the income
consumption curvebends backward between B and C.
Individual Demand
Engel Curves
• Engel curves relate the quantity of good consumed to income.
• If the good is a normal good, the Engel curve is upward sloping.
• If the good is an inferior good, the Engel curve is downward sloping.
Engel Curves
Food (unitsper month)
30
4 8 12
10
Income($ per
month)
20
160
Engel Curves
Food (unitsper month)
30
4 8 12
10
Income($ per
month)
20
16
Engel curves slopeupward for
normal goods.
0
Engel Curves
Hamburger (units per month)
30
5 10
10
Income($ per
month)
20
0
Engel Curves
Hamburger (units per month)
30
5 10
10
Income($ per
month)
20
Engel curves slopebackward bending for inferior goods.
0
Engel Curves
Hamburger (units per month)
30
5 10
10
Income($ per
month)
20
Engel curves slopebackward bending for inferior goods.
0
Inferior
Normal
Example: Consume Expenditures in the United States
Entertainment 520 894 1,185 1,602 2,018 2,565 4,007
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 1,514 748
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
Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000-($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above
Income Group (1993 $)
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
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
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!
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.
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 of the item demanded.
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.
– It usually still increases
Income and Substitution Effects
Income Effect
• Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.
Income and Substitution Effects--Normal Good
Food (units per month)O
R
Clothing(units per
month)
F1 S
C1
Originally, theconsumer is at A on budget line RS.
A
U1
Income and Substitution Effects--Normal Good
Food (units per month)O
R
Clothing(units per
month)
C2
F1 S F2 T
C1A
U1
When the price of foodfalls, consumption
increases by F1Fs asthe consumer
moves to B.
U2
B
Income and Substitution Effects--Normal Good
Food (units per month)O
R
Clothing(units per
month)
C2
F1 S F2 T
C1A
U1
U2
B
ETotal Effect
SubstitutionEffect
The substitution effect,F1E, (from points AD),
changes the relative pricesbut keeps real income
constant.
D
Income and Substitution Effects--Normal Good
Food (units per month)O
R
Clothing(units per
month)
C2
F1 S F2 T
C1A
U1
The income effect, EF2, (D to B) keeps relative
prices constant but increases purchasing power.
U2
B
ETotal Effect
SubstitutionEffect
Income Effect
D
Income and Substitution Effects--Inferior Good
Food (units per month)O
R
Clothing(units per
month)
F1 S
Originally, theconsumer is at A on budget line RS.
A
U1
Income and Substitution Effects--Inferior Good
Food (units per month)O
R
Clothing(units per
month)
F1 S T
A
U1
E
SubstitutionEffect
The substitution effect,F1E, (from points AD),
changes the relative pricesbut keeps real income
constant.
D
Income and Substitution Effects--Inferior Good
Since food is an inferior good, theincome effect is
negative. However,the substitution effect
is larger than the income effect.
Total Effect
Food (units per month)O
R
Clothing(units per
month)
F1 S F2 T
A
U1
E
SubstitutionEffect
D
B
Income Effect
U2
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.
Market Demand
From Individual to Market Demand
• Market demand curves are the horizontal summation of the individuals’ demand curves.
Determining the Market Demand Curve
1 6 10 1632
2 4 8 1325
3 2 6 1018
4 0 4 711
5 0 2 46
Price Individual A Individual B Individual C Market($) (units) (units) (units) (units)
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DA
The market demandcurve is obtained by
summing the consumer’s demand curves
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DA DB
The market demandcurve is obtained by
summing the consumer’s demand curves
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DA DB DC
The market demandcurve is obtained by
summing the consumer’s demand curves
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DA DB DC
Market Demand
The market demandcurve is obtained by
summing the consumer’s demand curves
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.
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.
PQ
PQ
P/P
Q/Q EP
/
/
Price Elasticity andConsumer Expenditure
If Price Increases, If Price Decreases,
Demand Expenditures Expenditures
Inelastic (Ep<1) Increase Decrease
Unit elastic (Ep=1) Are unchanged Are unchanged
Elastic (Ep>1) Decrease Increase
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.
Market Demand
Point and Arc Elasticities of Demand
• Point elasticity measures elasticity at a point on the demand curve.
• Its formula is:
ope)(P/Q)(1/sl E P
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.
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:
)/ QPP)(Q/( E P
Example:The AggregateDemand For Wheat
The demand for U.S. wheat is comprised of domestic demand and export demand.
Example:The 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
Example:The AggregateDemand For Wheat
Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4 to -0.5).
The Aggregate Demandfor Wheat
Quantity (millions of bushels per year)
Price ($/bushel)
02468
101214161820
1000 2000 3000 4000
A
C
B D
DomesticDemand
ExportDemand
The Aggregate Demandfor Wheat
Quantity (millions of bushels per year)
Price ($/bushel)
02468
101214161820
1000 2000 3000 4000
A
C
B D
DomesticDemand
ExportDemand
E
F
Total Demand
Total world demand is the horizontal sum of the domestic demand AB and
export demand CD.
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.
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14151617181920
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14151617181920 The consumer surplus
of purchasing 6 concerttickets is the sum of thesurplus derived from each one individually.
Market Price
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14151617181920
Market Price
ConsumerSurplus
The consumer surplusof purchasing 6 concerttickets is the sum of thesurplus derived from each one individually.
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14151617181920 The consumer’s
actual expenditureis the price times
the quantity purchased.
Market Price
ActualExpenditure
ConsumerSurplus
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
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14151617181920 For goods that cannot
be divided into smallparts the consumer surplus
is the yellow areabelow the demand curve.
ActualExpenditure
Demand Curve
Market Price
ConsumerSurplus
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
Example:The 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?
Example: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.
Valuing Clean Air
NOX (pphm)Pollution Reduction
Value($ per pphm
of reduction)
0
1000
2000
5 10
Valuing Clean Air
NOX (pphm)Pollution Reduction
Value($ per pphm
of reduction)
0
1000
2000
5 10
Valuing Clean Air
NOX (pphm)Pollution Reduction
Value($ per pphm
of reduction)
0
1000
2000
5 10
A
The shaded area gives theconsumer surplus generated
when air pollution is reduced by 5 parts per 100million of nitrous oxide at
a cost of $1000 per part reduced.