Chapter 3

Individual Demand Curves 2004 Thomson Learning/South-Western

Individual Demand CurvesThis chapter studies how people change their choices when conditions such as income or changes in the prices of goods affect the amount that people choose to consume.This chapter then compares the new choices with those that were made before conditions changedThe main result of this approach is to construct an individuals demand curve

Demand FunctionsIf we knew a persons preferences and all the economic forces that affect his or her choices, we could predict how much of each good would be chosen.This summarizes this information in a demand function: a representation of how quantity demanded depends on prices, income, and preferences.

Demand FunctionThe three elements that determine the quantity demanded are the prices of X and Y, the persons income (I), and the persons preferences for X and Y.Preferences appear to the right of the semicolon because we assume that preferences do not change during the analysis.

Homogeneous Demand FunctionIndividual demand functions are homogeneous since quantity demanded does not change when prices and income increase in the same proportion.The budget constraint PXX + PYY = I is identical to the budget constraint 2PXX + 2PYY = 2I.Graphically the lines are the same.

Changes in IncomeWhen a persons income increase, while prices remain the same, the quantity purchased of each good might increase.This situation is shown in Figure 3.1 where the increase in income is shown as the budget line shifts out from I1 to I2 to I3.The slope of the budget lines are the same since the prices have not changed .

FIGURE 3.1: Effect of Increasing Income on Quantities of X and Y ChosenQuantity of Yper weekU1I1Quantity of Xper weekX10Y1

FIGURE 3.1: Effect of Increasing Income on Quantities of X and Y ChosenQuantity of Yper weekU1I1Quantity of Xper weekX10X2Y2Y1U2I2

FIGURE 3.1: Effect of Increasing Income on Quantities of X and Y ChosenQuantity of Yper weekY3U1I1Quantity of Xper weekX10X2X3Y2Y1U2U3I2I3

Changes in IncomeIn response to the increase in income the quantity of X purchased increases from X1 to X2 and X3 while the quantity purchased of Y also increases from Y1 to Y2 to Y3.Increases in income make it possible for a person to consume more reflected in the outward shift in the budget constraint that allows an increase in overall utility.

Normal GoodsA normal good is one that is bought in greater quantities as income increases.If the quantity increases more rapidly than income the good is called a luxury good as with good Y in Figure 3.1.If the quantity increases less rapidly than income the good is called a necessity good as with good X in Figure 3.1.

APPLICATION 3.1: Engels LawOne important generalization about consumer behavior is that the fraction of income spent on food tends to decline as income increases.This finding was discovered by Prussian economists Ernst Engel (1821-1896).Table 1 show Engels data with Table 2 showing recent data for U.S. consumers.

TABLE 1: Percentage of Total Expenditures of Various Items in Belgian Families in 1853

Annual Income

Expenditure Item

$225-$300

$450-$600

$750-$1000

Food

62.0%

55.0%

50.0%

Clothing

16.0

18.0

18.0

Lodging, light, and fuel

17.0

17.0

17.0

Services (education, legal, health)

4.0

7.5

11.5

Comfort and recreation

1.0

2.5

3.5

Total

100.0

100.0

100.0

TABLE 2: Percentage of Total Expenditures by U.S. Consumers on Various Items, 2000

Annual Income (000)

Item

$15 - 20

$40 - 50

$70+

Food

15.4%

14.7%

11.4%

Clothing

4.8

4.7

5.3

Housing

32.9

30.4

30.2

Other Items

46.9

50.2

53.1

Total

100.0

100.0

100.0

Inferior GoodsAn inferior good is one that is bought in smaller quantities as income increases.In Figure 3.2 as income increases from I1 to I2 to I3, the consumption of inferior good Z decreases.Goods such as rotgut whiskey, potatoes, and secondhand clothing are examples of inferior goods.

FIGURE 3.2: Indifference Curve Map Showing InferiorityQuantity of Yper weekQuantity of Zper week0Z1Y1U1I1

FIGURE 3.2: Indifference Curve Map Showing InferiorityQuantity of Yper weekQuantity of Zper week0Z2Z1Y1Y2U1U2I1I2

FIGURE 3.2: Indifference Curve Map Showing InferiorityQuantity of Yper weekY3Quantity of Zper weekZ30Z2Z1Y1Y2U1U2U3I1I2I3

Changes in a Goods PriceA change in the price of one good causes both the slope and an intercept of the budget line to change.The change also involves moving to a new utility-maximizing choice on another indifference curve with a different MRS.The quantity demanded of the good whose price has changed changes.

Substitution EffectThe part of the change in quantity demanded that is caused by substitution of one good for another is called the substitution effect.This results in a movement along an indifference curve.Consumption has to be changed to equate MRS to the new price ratio of the two goods.

Income EffectThe part of the change in quantity demanded that is caused by a change in real income is called the income effect.The price change also changes real purchasing power and consumers will move to a new indifference curve that is consistent with this new purchasing power.

Substitution and Income Effects from a Fall in PriceAs shown in Figure 3.3, when the price of good X falls, the budget line rotates out from the unchanged Y axis so that the X intercept lies father out because the consumer can now buy more X with the lower price.The flatter slope means that the relative price of X to Y (PX/PY) has fallen.

Substitution Effect from a Fall in PriceThe consumer was originally maximizing utility at X*, Y* in Figure 3.3.After the fall in the price of good X, the new utility maximizing choice is X**, Y**.The substitution effect is the movement on the original indifference curve to point B.

FIGURE 3.3: Income and Substitution Effects of a Fall in PriceQuantity of Yper weekY*Quantity of Xper weekX*0U1

FIGURE 3.3: Income and Substitution Effects of a Fall in PriceQuantity of Yper weekY*Old budget constraintBSubstitutioneffectNew budget constraintQuantity of Xper weekX*XB0U1

FIGURE 3.3: Income and Substitution Effects of a Fall in PriceQuantity of Yper weekY**Y*Old budget constraintBSubstitutioneffectIncomeeffectTotal increase in XNew budget constraintQuantity of Xper weekX*XBX**0U1U2

Substitution Effect from a Fall in PriceIf the individual had to stay on the U1 with the new price ratio, the consumer would choose B since that is the point where the MRS is equal to the slope of the new budget line (shown by the dashed line).Staying on the same indifference curve is the same as holding real income constant.The consumer buys more good X.

Income EffectThe movement from point B to X**, Y** results from the increase in purchasing power.Because PX falls but nominal income (I) remains the same, the individuals real income increases so that he or she can be on utility level U3.The consumer buys more good X.

The Effects CombinedUsing the hamburger-soft drink example from Chapter 2, suppose the price of soft drinks falls from $.50 to $.25.Previously the consumer could purchase up to 20 soft drinks, but now he or she can purchase up to 40.This price decrease shifts the budget line outward and increases utility.

The Effects CombinedIf the consumer bought his or her previous choice it would now cost $7.50 so that $2.50 would be unspent.If the individual stayed on the old indifference curve he or she would equate MRS to the new price ratio (consuming 1 hamburger and 4 soft drinks).This move is the substitution effect.

The Effects CombinedEven with constant real income the consumer will buy more soft drinks since the opportunity cost of eating a burger in terms of the soft drinks forgone is now higher.Since real income has increased the person will choose to buy more soft drinks so long as soft drinks are a normal good.

Substitution and Income Effects from an Increase in PriceAn increase in PX will shift the budget line in as shown in Figure 3.4.The substitution effect, holding real income constant, is the move on U2 from X*, Y* to point B.Because the higher price causes purchasing power to decrease, the movement from B to X**, Y** is the income effect.

FIGURE 3.4: Income and Substitution Effects of an Increase in PriceQuantity of Yper weekY*New budget constraintOld budget constraintQuantity of Xper weekX*0U2

FIGURE 3.4: Income and Substitution Effects of an Increase in PriceQuantity of Yper weekY*New budget constraintSubstitutioneffectOld budget constraintBQuantity of Xper weekXBX*0U1U2

FIGURE 3.4: Income and Substitution Effects of an Increase in PriceQuantity of Yper weekY**Y*New budget constraintIncomeeffectSubstitutioneffectTotal reductionin XOld budget constraintBQuantity of Xper weekX**XBX*0U1U2

Substitution and Income Effects from an Increase in PriceIn Figure 3.4, both the substitution and income effects cause the individual to purchase less soft drinks do to the higher price of soft drinks.

Substitution and Income Effects for a Normal Good: SummaryAs shown in Figures 3.3 and 3.4, the substitution and income effects work in the same direction with a normal good.When the price falls, both the substitution and income effects result in more purchased.When the price increases, both the substitution and income effects result in less purchased.

Substitution and Income Effects for a Normal Good: SummaryThis provides the rational for drawing downward sloping demand curves.This also helps to determine the steepness of the demand curve.If either the substitution or income effects are large, the change in quantity demanded will be large with a given price change.

Substitution and Income Effects for a Normal Good: SummaryIf the substitution and income effects are small, the effect of a given price change in the quantity demanded will also be small.This kind of analysis also offers a number of insights about some commonly used economic statistics.

APPLICATION 3.2: The Consumer Price Index and Its BiasesThe Bureau of Labor Statistics monthly calculates the Consumer Price Index (CPI) which is a principal measure of inflation in the U.S..To construct the CPI, a typical market basket of commodities purchased by consumers in the base year (currently 1982) is calculated.

APPLICATION 3.2: The Consumer Price Index and Its BiasesThe ratio of the current cost of the basket to the base year price is the measure of the value of the CPI.The rate of change in the CPI between two periods is the reported rate of inflation.

An Algebraic ExampleSuppose the 1982 typical market basket contained X82 of good X and Y82 of good Y.The prices of these goods are and The cost of this bundle in the 1982 base year would be written as

An Algebraic ExampleTo compute the cost of the same bundle of goods in, say 2002, requires that we compute the cost of the bundle using current prices

An Algebraic ExampleThe CPI is defined as the ratio of the costs of these two market baskets

If the basket cost $100 in 1982 prices and $180 in 2002, the value of the CPI would be 1.80 and with a measured 80 percent increase in prices over the 20 year period.

Substitution Bias in the CPIThe CPI does not take into account the real possibility that consumers would substitute among commodities because of changes in relative prices.In Figure 1, the typical individual is initially consuming X82, Y82 maximizing utility on U1 with 1982 constraint I.

FIGURE 1: Substitution Bias of the Consumer Price IndexQuantity ofY per yearY82Quantity ofX per yearU1III0X82

Substitution Bias in the CPISuppose the 2002 relative prices change so that PX/PY falls.The cost of the 1982 bundle in terms of 2002 prices is reflected in the constraint I which is flatter and goes though the 1982 bundle.The consumer would substitute X for Y and stay on U1 on budget line I.

Substitution Bias in the CPISince I is inside I (which is used to compute the CPI), the CPI tends to overstate the inflation rate.Unfortunately, adjusting the CPI to take such substitution into account is difficult because it would require that we know the utility function of the typical consumer.

New Product Bias in the CPINew products typically experience sharp declines in prices and rapidly grow in rates of acceptance.If the CPI does not include these new products, this source of welfare increase is omitted.The CPI basket is revised but not rapidly enough to eliminate this bias.

Outlet Bias in the CPIThe typical basket is bought at the same retail outlets every month.This method can omit the benefits of sales or other bargains.The CPI does not currently take such price-reducing strategies and thus tends to overstate inflation.

Consequences of the CPI BiasesMeasuring and correcting for these biases is not an easy task.The CPI is such a widely used measure of inflation that any change becomes a hot political issue.However, there is a general agreement that the CPI overstates inflation by as much as 0.75 to 1.0 percent per year.

Consequences of the CPI BiasesPoliticians have proposed caps on Cost of Living Adjustments (COLAs) tied to the CPI on government programs, but none have yet been enacted.However, the private sector has adjusted so that few private COLAs provide full offsets to inflation measured by the CPI.

Substitution and Income Effects for Inferior GoodsWith an inferior good, the substitution effect and the income effects work in opposite directions.The substitution effect results in decreased consumption for a price increase and increased consumption for a price decrease.

Substitution and Income Effects for Inferior GoodsThe income effect results in increased consumption for a price increase and decreased consumption for a price decrease.Figure 3.5 shows the two effects for an increase in PX.The substitution effect, holding real income constant, is shown by the move from X*, Y* to point B both on U2.

FIGURE 3.5: Income and Substitution Effects for an Inferior GoodQuantity of Yper weekY*Old budget constraintU2Quantity of Xper weekX*0

FIGURE 3.5: Income and Substitution Effects for an Inferior GoodQuantity of Yper weekY**Y*New budget constraintOld budget constraintU2BQuantity of Xper weekX*0U1

FIGURE 3.5: Income and Substitution Effects for an Inferior GoodQuantity of Yper weekY**Y*New budget constraintOld budget constraintU2BQuantity of Xper weekX**X*0U1

Substitution and Income Effects for Inferior GoodsThe income effect reflects the reduced purchasing power due to the price increase.Since X is an inferior good, the decrease in income results in an increase in the consumption of X shown by the move from point B on U1 to the new utility maximizing point X**, Y** on U1.

Substitution and Income Effects for Inferior GoodsSince X** is less than X* the price increase in X results in a decrease in the consumption of X.This occurs because the substitution effect, in this example, is bigger than the income effect.Thus, if the substitution effect dominates, the demand curve is negatively sloped.

Giffens ParadoxIf the income effect of a price change is strong enough with an inferior good, it is possible for the quantity demanded to change in the same direction as the price change.Legend has it that this phenomenon was observed by English economist Robert Giffen.

Giffens ParadoxWhen the price of potatoes rose in Ireland the consumption of potatoes also increased.Potatoes were not only an inferior good but constituted the source of a large portion of Irish peoples income.The situation I which an increase in a goods price leads people to consume more of the good is called Giffens paradox.

The Lump Sum PrincipleThe lump-sum principle hold that taxes that are imposed on general purchasing power will have a smaller welfare costs than will taxes imposed on a narrow selection of commodities.Consider Figure 3.6 where the individual initially has I dollars to spend and chooses to consume X* and Y* yielding U3 utility.

FIGURE 3.6: The Lump-Sum PrincipleQuantity of YY*IQuantity of Xper weekX*U3

The Lump Sum PrincipleA tax on only good X raises its price resulting in budget constraint I and consumption reduced to X1, Y1 and utility level U1.A general income tax that generates the same total tax revenue is represented by budget constraint I that goes though X1, Y1.

FIGURE 3.6: The Lump-Sum PrincipleQuantity of YY*IQuantity of Xper weekX1X*Y1Y2IU1U3

FIGURE 3.6: The Lump-Sum PrincipleQuantity of YY*IQuantity of Xper weekX1X2X*Y1Y2IIU1U2U3

The Lump Sum PrincipleThe utility maximizing choice on I is X2, Y2 yielding utility level U2.The lump-sum general income tax generates the same amount of tax revenue but leaves the consumer on a higher utility level (U2) than the utility level associated with the tax only on good X (U1).

The Lump Sum PrincipleThe intuitive explanation of the lump-sum principle is that a single-commodity tax affects people in two ways:it reduces their purchasing power,it directs consumption away from the good being taxed.The lump-sum tax only has the first of these two effects.

Generalizations of the Lump-Sum PrincipleThe utility lass associated with the need to collect a certain amount of tax revenue will be minimized by taxing goods for which the substitution effect is small.Even though the tax will reduce purchasing power, it will minimize the impact of directing consumption away from the good being taxed.

APPLICATION 3.3: Wouldnt Cash Be a Better Way to Help Poor People?The lump-sum principle suggests that the trends in expanding in-kind programs may be unfortunateThese programs do not generate as much welfare for people as would the spending of the same funds in a cash program

APPLICATION 3.3: Wouldnt Cash Be a Better Way to Help Poor People?In Figure 1 a subsidy on good X (constraint I) raises utility to U2For the same funds, an income grant (I) raises utility to U3

FIGURE 1: The Superiority of an Income GrantY per periodIX per periodIU1U2BU3I

Changes in the Price of Another GoodWhen the price of one good changes, it usually has an affect on the demand for the other good.In Figure 3.3, the increase in the price of X (a normal good) caused both an income and substitution effect that caused a reduction in the quantity demanded of X.

Changes in the Price of Another GoodIn addition, the substitution effect caused a decrease in the demand for good Y as the consumer substituted good X for good Y.However, the increase in purchasing power brought about by the price decrease causes an increase in the demand for good Y (also a normal good).

Changes in the Price of Another GoodSince, in this case, the income effect had a dominant effect on good Y, the consumption of Y increased due to a decrease in the price of good X.With flatter indifference curves as shown in Figure 3.7, the situation is reversed.A decrease in the price of good X causes a decrease in good Y, as before.

FIGURE 3.7: Effect on the Demand for Good Y of a Decrease in the Price of Good XQuantity of Yper weekY*U1Quantity of Xper weekOld budget constraintX*0

FIGURE 3.7: Effect on the Demand for Good Y of a Decrease in the Price of Good XQuantity of Yper weekY*U2U1Quantity of Xper weekNew budget constraintOld budget constraintX*B0A

FIGURE 3.7: Effect on the Demand for Good Y of a Decrease in the Price of Good XQuantity of Yper weekY**Y*U2U1Quantity of Xper weekNew budget constraintOld budget constraintX*X**B0AC

Changes in the Price of Another GoodHowever, in this case, the income effect is much smaller than the substitution effect so that the consumer ends up consuming less of good Y at Y** after the decrease in the price of X.Thus, the effect of a change in the price of one good has an ambiguous effect on the demand for the other good.

ComplementsComplements are goods that go together in the sense that people will increase their use of both goods simultaneously.Two goods are complements if an increase in the price of one causes a decrease in the demanded of the other or a decrease in the price of one good causes an increase in the demand for the other.

SubstitutesSubstitutes are goods that are goods that are used for essentially the same purpose.Two goods such that if the price of one increases, the demand for the other rises are substitutes.If the price of one good decreases and the demand for the other good decreases, they are also substitutes.

APPLICATION 3.4: Why Are So Many Trucks on the Road?There has been a huge gain in truck registrations over the past 10 yearsThe Department of Transportation regards a wide variety of automobile-like vehicles as trucks (like vans, minivans, and SUVs)One of the most important reasons in the trend toward SUVs has been a sharp decline in real gasoline pricesThere has been a substitution away from more traditional automobiles.

Construction of Individual Demand CurvesAn individual demand curve is a graphic representation between the price of a good and the quantity of it demanded by a person holding all other factors (preferences, the prices of other goods, and income) constant.Demand curves limit the study to the relationship between the quantity demanded and changes in the own price of the good.

Construction of Individual Demand CurvesIn Panel a of Figure 3.8 an individuals indifference curve map is drawn using three different budget constraints in which the price of X decreases.The decreasing prices are PX, PX, and PX respectively.The individuals utility maximizing choices of X are X, X, and X respectively.

FIGURE 3.8: Construction of an Individuals Demand CurveQuantity of Yper weekU1XQuantity of Xper weekBudget constraint for P9X(a) Individuals indifference curve map0PricePXQuantity of Xper weekX(b) Demand curve0

FIGURE 3.8: Construction of an Individuals Demand CurveQuantity of Yper weekU1U2Quantity of Xper weekBudget constraint for PXBudget constraint for PXXXX(a) Individuals indifference curve map0PriceQuantity of Xper weekXX(b) Demand curve0PXPX

FIGURE 3.8: Construction of an Individuals Demand CurveQuantity of Yper weekU1U2U3XQuantity of Xper weekXXX(a) Individuals indifference curve map0PriceP9XP0XP-Quantity of Xper weekXXX(b) Demand curve0Budget constraint for PXBudget constraint for PXBudget constraint for PX

FIGURE 3.8: Construction of an Individuals Demand CurveQuantity of Yper weekU1U2U3XQuantity of Xper weekXXX(a) Individuals indifference curve map0PriceP9XP0XP-dXQuantity of Xper weekXXX(b) Demand curve0Budget constraint for PXBudget constraint for PXBudget constraint for PX

Construction of Individual Demand CurvesThese three choices show that the quantity demanded of X increases as the price of X falls.Panel b shows how the three price and quantity choices can be used to construct the demand curve.

Construction of Individual Demand CurvesThe price of X is shown on the vertical axis and the quantity of X is shown on the horizontal axis.The demand curve (dX) is downward sloping showing that when the price of X falls, the quantity demanded of X increases.As previously shown, this result follows from the substitution and income effects.

Shape of the Demand CurveIf a good, say X, has close substitutes, a increase in its price will cause a large decrease in the quantity demanded as the substitution effect will be large.The demand curve for a type of breakfast cereal will likely be relatively flat due to the strong substitution effect.

Shape of the Demand CurveIf the good has few substitutes, the substitution effect of a price increase or decrease will be small and the demand curve will be relatively steep.Water is an example of a good with few substitutes.

Shape of the Demand CurveFood has no substitutes so it might be thought that no change in consumption would occur with a price increase.But food constitutes a large part of an individuals budget so that price changes will cause relatively larger effects on the quantity demanded that might be thought due to the income effect.

Shifts in an Individuals Demand CurveWhen one of the variables that are held constant (price of another good, income or preferences) on a demand curve changes, the entire curve shifts.Figure 3.9 shows the kinds of shifts that might take place.If X is a normal good and income increases, demand increases as shown in Panel a.

FIGURE 3.9: Shifts in Individuals Demand Curve(a)P1X0(b)X0(c)X0PXPXPXP1P1X1X1X1X2X2X2

FIGURE 3.9: Shifts in Individuals Demand Curve(a)P1X0(b)X0(c)X0PXPXPXP1P1X1X1X1X2X2X2

Shifts in an Individuals Demand CurveIf X and Y are substitutes and the price of Y increases, the demand for X increases as shown in Panel b.Alternatively, if X and Y are complements, the increase in the price of Y will cause a decrease in the demand for X as shown in Panel c.

Shifts in an Individuals Demand CurveChanges in preferences can also shift demand curves.Panel b could represent an increased preference for cold drinks when a sudden hot spell occurs.Increased environmental consciousness during the 1980s and 1990s increased the demand for recycling and organic food.

APPLICATION 3.5: Fads, Seasons, and Health ScaresFads (sometimes termed bandwagon effects) are when preferences cause extremely large increases in demand followed later by large decreases in demand.While fads are hard to predict, seasonal items are easy to predict.Increased demand for turkeys in November and Christmas trees are examples.

APPLICATION 3.5: Fads, Seasons, and Health ScaresHealth scares can cause large decreases in the demand for products.Examples include the long term decline in smoking and the decreased demand for Chinese food because of the concern for its fat content.Recent scientific studies have also affected demand such as the increase in the demand for tomatoes in 1998.

Be Careful in Using TerminologyA movement downward along a stationary demand curve in response to a fall in price is called an increase in quantity demanded while a rise in the price of the good results in a decrease in quantity demanded.A rightward shift in a demand curve is called an increase in demand while a leftward shift is a decrease in demand.

Consumer SurplusThe extra value individuals receive from consuming a good over what they pay for it is called consumer surplus.Consumer surplus is also what people would be willing to pay for the right to consume a good at its current price.This concept is used to study the welfare effects of price changes.

Consumer SurplusThe demand curve for T-shirts is shown in Figure 3.10.At the price of $11 the individual chooses to consume ten T-shirts.In other words, the individual is willing to pay $11 for the tenth T-shirt that they buy.With a price of $9, the individual chooses fifteen T-shirts, so implicitly they value the fifteenth shirt at only $9.

Consumer SurplusBecause a good is usually sold at a single market price, people choose to buy additional units of the good up to the point at which their marginal valuation is equal to the price.In Figure 3.10, if T-shirts sell for $7, the individual will buy twenty shirts because the twentieth T-shirt is worth precisely $7.They will not buy the twenty-first T-shirt because it is worth less than $7.

Consumer SurplusBecause the individual would be willing to pay more than $7 for the tenth or fifteenth T-shirt, it is clear that they get a surplus on those shirts because the individual is actually paying less than the maximal amount that they would be willing to pay.Consumer surplus is the difference between the maximal amounts a person would pay for a good and what he or she actually pays.

Consumer SurplusIn graphical terms, consumer surplus is given by the area below the demand curve and above the market price.In Figure 3.10, total consumer surplus is given by area AEB ($80).

FIGURE 3.10: Consumer Surplus from T-Shirt Demand Price ($/shirt)Price ($/shirt)15dQuantity (shirts)E119AB151020

Consumer Surplus and UtilityFigure 3.11 illustrates the connection between consumer surplus and utilityInitially, the person is at E with utility U1.He or she would need to be compensated by amount AB in other goods to get U1 if T-shirts were not available.

Consumer Surplus and UtilityIn Figure 3.11, the individual would be willing to pay BC for the right to consume T-shirts rather than spending I only on other goods.Both distance AB and BC approximate the consumer surplus area in Figure 3.10.

FIGURE 3.11: Consumer Surplus and UtilityPrice ($/shirt)IQuantity (shirts)ECAB20IU1U0

APPLICATION 3.6: Valuing Clean AirBy looking at the ceteris paribus relationship between air pollution levels in various locations and the prices of houses in these locations, it is possible to infer the amount that people will pay to avoid dirty air.This information allows the computation of a compensated demand curve for clean air.

APPLICATION 3.6: Valuing Clean AirIn Figure 1, the vertical axis shows the price home buyers are willing to pay to avoid air pollution and the horizontal axis shows the quantity of clean air purchased.The national average is reflected at point E as home buyers pay $50 and consume an average of 55 micrograms of suspended particulates per cubic meter.

FIGURE 1: Compensated Demand Curve for Clean AirPrice($)808550604020DAir quality(mg/m3)755055250E100

APPLICATION 3.6: Valuing Clean AirConsumers are paying $2,250 ($50 times 45 micrograms) extra to avoid dirty air.At E0 consumers also receive a consumer surplus equal to the shaded area in Figure 1.This consumer surplus of 788 per household can be multiplied by the total number of households to estimate total consumer surplus from clean air.