chapter 4
DESCRIPTION
Chapter 4. Individual and Market Demand. Topics to be Discussed. Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Network Externalities Empirical Estimation of Demand. Individual Demand. Price Changes - PowerPoint PPT PresentationTRANSCRIPT
Chapter 4
Individual and Market Demand
Chapter 4 2©2005 Pearson Education, Inc.
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Empirical Estimation of Demand
Chapter 4 3©2005 Pearson Education, Inc.
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
Chapter 4 4©2005 Pearson Education, Inc.
Effect of a Price Change
Each price leads to different amounts of
food purchased5
U3
D
4
U2
B
12 20
Assume: • I = $20• PC = $2• PF = $2, $1, $0.50
Food (units per month)
Clothing
6 A
U1
4
10
Chapter 4 5©2005 Pearson Education, Inc.
Effect of a Price Change
The Price-Consumption Curve traces out the utility maximizing market
basket for each price of food
4
U2
B
12 20
5
U3
D
Food (units per month)
Clothing
6 A
U1
4
10
Chapter 4 6©2005 Pearson Education, Inc.
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
P Q
$2.00 4
$1.00 12
$0.50 20
Chapter 4 7©2005 Pearson Education, Inc.
Effect of a Price Change
Demand Curve
Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50
Chapter 4 8©2005 Pearson Education, Inc.
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
Chapter 4 9©2005 Pearson Education, Inc.
Effect of a Price Change
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50Demand Curve
• E: Pf /Pc = 2/2 = 1 = MRS• G: Pf /Pc = 1/2 = .5 = MRS• H:Pf /Pc = .5/2 = .25 = MRS
When the price falls, Pf /Pc & MRS also fall
Chapter 4 10©2005 Pearson Education, Inc.
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
Chapter 4 11©2005 Pearson Education, Inc.
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
4
A U1
5
10
B
U2
D7
16
U3
Assume: Pf = $1, Pc = $2 I = $10, $20, $30
Chapter 4 12©2005 Pearson Education, Inc.
Individual Demand
Income Changes The income-consumption curve traces out
the utility-maximizing combinations of food and clothing associated with every income level
Chapter 4 13©2005 Pearson Education, Inc.
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
Chapter 4 14©2005 Pearson Education, Inc.
Effects of Income Changes
Food (units per month)
Clothing(units per
month)
The Income Consumption Curve traces out the utility maximizing market basket for each income level
3
4
A U1
5
10
B
U2
D7
16
U3
Income Consumption Curve
Chapter 4 15©2005 Pearson Education, Inc.
Effects of Income Changes
Food (units per month)
Priceof
food
An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right as well.
$1.00
4
D1
E
10
D2
G
16
D3
H
Chapter 4 16©2005 Pearson Education, Inc.
Individual Demand
Income Changes When the income-consumption curve has a
positive slope:The quantity demanded increases with incomeThe income elasticity of demand is positiveThe good is a normal good
Chapter 4 17©2005 Pearson Education, Inc.
Individual Demand
Income Changes When the income-consumption curve has a
negative slope:The quantity demanded decreases with incomeThe income elasticity of demand is negativeThe good is an inferior good
Chapter 4 18©2005 Pearson Education, Inc.
An Inferior Good
Hamburger (units per month)
Steak(units per
month)
30
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes an inferior
good when the incomeconsumption curvebends backward between B and C.
105
AU1
5
20
10
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
Chapter 4 19©2005 Pearson Education, Inc.
Individual Demand
Engel Curves Engel curves relate the quantity of good
consumed to income If the good is a normal good, the Engel curve
is upward sloping If the good is an inferior good, the Engel
curve is downward sloping
Chapter 4 20©2005 Pearson Education, Inc.
Engel Curves
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Engel curves slopeupward for
normal goods.
Chapter 4 21©2005 Pearson Education, Inc.
Engel Curves
Engel curves arebackward bending for inferior goods.
Inferior
Normal
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Chapter 4 22©2005 Pearson Education, Inc.
Annual US Household Consumer Expenditures
Chapter 4 23©2005 Pearson Education, Inc.
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
Chapter 4 24©2005 Pearson Education, Inc.
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
Chapter 4 25©2005 Pearson Education, Inc.
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
Chapter 4 26©2005 Pearson Education, Inc.
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
Chapter 4 27©2005 Pearson Education, Inc.
Income and Substitution Effects
A change in the price of a good has two effects: Substitution Effect Income Effect
Chapter 4 28©2005 Pearson Education, Inc.
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
Chapter 4 29©2005 Pearson Education, Inc.
Income and Substitution Effects
Income Effect Consumers experience an increase in real
purchasing power when the price of one good falls
Chapter 4 30©2005 Pearson Education, Inc.
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 demanded of the good
Chapter 4 31©2005 Pearson Education, Inc.
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
Chapter 4 32©2005 Pearson Education, Inc.
Income and Substitution Effects
Income Effect Even with inferior goods, the income effect is
rarely large enough to outweigh the substitution effect
Chapter 4 33©2005 Pearson Education, Inc.
Income and SubstitutionEffects: Normal Good
Food (units per month)O
Clothing(units per
month) R
F1 S
C1 A
U1
The income effect, EF2, (from D to B) keeps relativeprices constant but increases purchasing power.
Income Effect
C2
F2 T
U2
B
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.
ETotal Effect
SubstitutionEffect
D
The substitution effect, F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.
Chapter 4 34©2005 Pearson Education, Inc.
Food (units per month)O
R
Clothing(units per
month)
F1 S F2 T
A
U1
E
SubstitutionEffect
D
Total Effect
Since food is an inferior good, theincome effect is
negative. However,the substitution effect
is larger than the income effect.
B
Income Effect
U2
Income and SubstitutionEffects: Inferior Good
Chapter 4 35©2005 Pearson Education, Inc.
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
Chapter 4 36©2005 Pearson Education, Inc.
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
Chapter 4 37©2005 Pearson Education, Inc.
Determining the Market Demand Curve
Price A B CMarket
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
Chapter 4 38©2005 Pearson Education, Inc.
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DB DC
Market Demand
DA
The market demandcurve is obtained by
summing the consumer’s demand curves
Chapter 4 39©2005 Pearson Education, Inc.
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
Chapter 4 40©2005 Pearson Education, Inc.
Market Demand
Aggregation is important to be able to discuss regarding demand for different groups Households with children Consumers aged 20 – 30, etc.
Chapter 4 41©2005 Pearson Education, Inc.
Market Demand
Price Elasticity of Demand Measures the percentage change in the
quantity demanded resulting from a percent change in price
Q
P
P
Q
P/P
Q/Q
P%
Q% EP
Chapter 4 42©2005 Pearson Education, Inc.
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| < |%P| Total expenditure (P*Q) increases when
price increases
Chapter 4 43©2005 Pearson Education, Inc.
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| > |%P| Total expenditure (P*Q) decreases when
price increases
Chapter 4 44©2005 Pearson Education, Inc.
Price Elasticity andConsumer Expenditure
Chapter 4 45©2005 Pearson Education, Inc.
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)
Chapter 4 46©2005 Pearson Education, Inc.
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
Chapter 4 47©2005 Pearson Education, Inc.
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
Chapter 4 48©2005 Pearson Education, Inc.
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
Chapter 4 49©2005 Pearson Education, Inc.
C
D
ExportDemand
Total world demand is the horizontal sum of the domestic demand AB and
export demand CD.
F
Total Demand
A
B
DomesticDemand
E
The Aggregate Demand for Wheat
Wheat
Price
0
10
16
18
Above C, export demand is zero, so domestic demand = total demand = AE segment
Chapter 4 50©2005 Pearson Education, Inc.
Consumer Surplus
Consumers buy goods because it makes them better off
Consumer Surplus measures how much better off they are
Chapter 4 51©2005 Pearson Education, Inc.
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
Chapter 4 52©2005 Pearson Education, Inc.
Consumer Surplus - Example
Student wants to buy concert ticketsDemand curve tells us willingness to pay
for each concert ticket 1st ticket worth $20 but price is $14 so
student generates $6 worth of surplus Can measure this for each ticket Total surplus is addition of surplus for each
ticket purchased
Chapter 4 53©2005 Pearson Education, Inc.
The consumer surplusof purchasing 6 concerttickets is the sum of the
surplus derived from each one individually.
Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21
Consumer Surplus - Example
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Will not buy more than 7 because surplus is negative
Chapter 4 54©2005 Pearson Education, Inc.
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
Chapter 4 55©2005 Pearson Education, Inc.
Demand Curve
ConsumerSurplus
Consumer Surplusfor the Market Demand
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
ActualExpenditure
14
15
16
17
18
19
20
Market Price
CS = ½ ($20 - $14)*(1600) = $19,500
Chapter 4 56©2005 Pearson Education, Inc.
Applying 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
Chapter 4 57©2005 Pearson Education, Inc.
Applying Consumer Surplus – An Example
The Value of Clean Air Air is free in the sense that we don’t pay to
breathe it The Clean Air Act was amended in 1970 Question: Were the benefits of cleaning up
the air worth the costs?
Chapter 4 58©2005 Pearson Education, Inc.
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
Chapter 4 59©2005 Pearson Education, Inc.
The Value of Cleaner Air
Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve
Chapter 4 60©2005 Pearson Education, Inc.
The shaded area represents theconsumer surplus generated
when air pollution is reduced by 5 parts per 100million of nitrous oxide at
a cost of $1000 per part reduced.
Valuing Cleaner Air
2000
100
1000
5
A
NOX (pphm)Pollution Reduction
Value
Chapter 4 61©2005 Pearson Education, Inc.
Value of Cleaner Air
A full cost-benefit analysis would include total benefit of cleanup
Total benefits would be compared to total costs to determine if the clean up was worthwhile
Chapter 4 62©2005 Pearson Education, Inc.
Network Externalities
Up to this point we have assumed that people’s demands for a good are independent of one another
For some goods, one person’s demand also depends on the demands of other people
Chapter 4 63©2005 Pearson Education, Inc.
Network Externalities
If this is the case, a network externality exists
Network externalities can be positive or negative
Chapter 4 64©2005 Pearson Education, Inc.
Network Externalities
A positive network externality exists if the quantity of a good demanded by a consumer increases in response to an increase in purchases by other consumers
Negative network externalities are just the opposite
Chapter 4 65©2005 Pearson Education, Inc.
Network Externalities
The Bandwagon Effect This is the desire to be in style, to have a
good because almost everyone else has it, or to indulge in a fad
This is the major objective of marketing and advertising campaigns (e.g. toys, clothing)
Positive network externality in which a consumer wishes to possess a good in part because others do
Chapter 4 66©2005 Pearson Education, Inc.
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20
When consumers believe more people have purchased theproduct, the demand curve shifts further to the the right.
40
D40
60
D60
80
D80
100
D100
Chapter 4 67©2005 Pearson Education, Inc.
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20
The market demandcurve is found by joiningthe points on the individual demand curves. It is relativelymore elastic.
40
D40
60
D60
80
D80
100
D100
Demand
Chapter 4 68©2005 Pearson Education, Inc.
Positive NetworkExternality: Bandwagon Effect
Quantity (thousands per month)
Price($ per
unit)
D20
20
Suppose the price fallsfrom $30 to $20. If there were no bandwagon effect,quantity demanded wouldonly increase to 48,000
40
D40
60
D60
80
D80
100
D100
Demand
But as more people buythe good, it becomes stylish to own it and
the quantity demandedincreases further.
$30
48
$20
Pure PriceEffect
BandwagonEffect
Chapter 4 69©2005 Pearson Education, Inc.
Network Externalities
The Snob Effect If the network externality is negative, a snob
effect exists
The snob effect refers to the desire to own exclusive or unique goods
The quantity demanded of a “snob” good is higher the fewer the people who own it
Chapter 4 70©2005 Pearson Education, Inc.
Network Externality: Snob Effect
Quantity (thousandsper month)
Price($ per
unit)
2
Demand
D2
$30,000
$15,000
14
Originally demand is D2,when consumers think 2,000people have bought a good.
4 6 8
D4
D6D8
However, if consumers think 4,000 people have bought the good,
demand shifts from D2 to D6 and its snob value has been reduced.
Pure Price Effect
Chapter 4 71©2005 Pearson Education, Inc.
Network Externality: Snob Effect
Quantity (thousandsper month)
Price($ per
unit)
2
Demand
D2
$30,000
$15,000
144 6 8
D4
D6D8
Pure Price Effect
The demand is less elastic and as a snob good its value is greatly
reduced if more people ownit. Sales decrease as a result.
Examples: Rolex watches and long lines at the ski lift.
Net Effect Snob Effect
Chapter 4 72©2005 Pearson Education, Inc.
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
Chapter 4 73©2005 Pearson Education, Inc.
Empirical Estimation of Demand
Problem Consumers may lack information or interest,
or be misled by the interviewer
Chapter 4 74©2005 Pearson Education, Inc.
Empirical Estimation of Demand
In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed
Chapter 4 75©2005 Pearson Education, Inc.
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
Chapter 4 76©2005 Pearson Education, Inc.
Demand Data for Raspberries
Chapter 4 77©2005 Pearson Education, Inc.
Empirical Estimation of Demand
Assuming only price determines demand: Q = a - bP Q = 28.2 -1.00P
Chapter 4 78©2005 Pearson Education, Inc.
Estimating Demand
Quantity
Price
0 5 10 15 20 25
15
10
5
25
20
d1
d2
d3
D
D represents demandif only P determinesdemand and then from the data: Q=28.2-1.00P
Chapter 4 79©2005 Pearson Education, Inc.
Estimating Demand – Changes in Income
Quantity
Price
0 5 10 15 20 25
15
10
5
25
20
D
d1
d2
d3
d1, d2, d3 represent the demand for each income level. Including income in the demand equation: Q = a - bP + cI or Q = 8.08 - .49P + .81I
Chapter 4 80©2005 Pearson Education, Inc.
Empirical Estimation of Demand
Estimating Elasticities For the demand equation: Q = a - bP
Elasticity:
)/()/)(/( QPbQPPQEP
Chapter 4 81©2005 Pearson Education, Inc.
Empirical Estimation of Demand
Assuming: Price and income elasticity are constant The isoelastic demand =
)log()log()log( IcPbaQ
The slope, -b = price elasticity of demandConstant, c = income elasticity of demand
Chapter 4 82©2005 Pearson Education, Inc.
Empirical Estimation of Demand
Using the Raspberry data:
)log(46.1)log(4.281.0)log( IPQ
Price elasticity = -0.24 (Inelastic)Income elasticity = 1.46
Chapter 4 83©2005 Pearson Education, Inc.
Empirical Estimation of Demand
Substitutes: b2 is positive
Complements: b2 is negative
)log(log)log()log( 22 IcPbPbaQ
Complements and Substitutes
Chapter 4 84©2005 Pearson Education, Inc.
The Demand for Ready-to-Eat Cereal
Are Grape Nuts and Spoon Size Shredded Wheat good substitutes? Estimated demand for Grape Nuts (GN)
)log(14.0)log(62.0)log(085.2998.1)log( SWGNGN PIPQ
Price elasticity = -2.0Income elasticity = 0.62Cross elasticity = 0.14