Chapter 4 – Individual and

Market Demand.Goals:

• Generate an individual consumer’s demand curve.

* Substitution and Income Effect of a Change

in Price.

* How a change in Income affects the demand

curve.

• Generate the market demand curve from (many)

individual consumer’s demand curve.

* Price Elasticity of Demand.

Individual Consumer’s Demand

Curve. The Effect of Changes in Price.

◦ Price-Consumption Curve (PCC): Holding

everything else constant, the PCC for a good

X is the set of optimal bundles traced on an

indifference map as the price of X varies.

◦ Consider the case when the price of the good

X goes down.

Individual Consumer’s Demand

Curve. The Effect of Changes in Price.

◦ The Substitution Effect: When price of one

good increases, consumer will substitute away

from the now more expensive good.

◦ The Income Effect : When price of one good

increases, the real income that a consumer has

is also reduced.

◦ Total Effect: The sum of Substitution Effect and

Income Effect.

Income and Substitution Effect

of a Normal Good.

Income and Substitution Effects

of an Inferior Good.

Individual Consumer’s Demand

Curve.

An Increase In Price of Good X

Effects Normal Good Inferior Good

Substitution Effect - -

Income Effect - +

Total Effect - -/+

Individual Consumer’s Demand

Curve. The Effects of Changes in Income (holding

prices constant).

◦ The income consumption curve (ICC):

Ceteris paribus, in good X, Y domain, the ICC

is the set of optimal bundles traced on an

indifference map as money income varies.

◦ In Income and Quantity domain, the ICC is

referred to as the Engel Curve.

Normal Good: Upward sloping Engel Curve.

Inferior Good: Downward sloping Engel Curve.

Market Demand.

Aggregating individual demand curves.

◦ Consider the case where we have 2 individuals

in the market. Each individual has his/her own

demand for good X. Suppose

(D1): P = 10 – X1 => X1 = 10 – P.

(D2):P = 10 – 2X2 => X2 = 5 – 1/2P.

XAgg = X1 + X2 = 15 – 3/2P. => (D): P = 10 – 2/3 XAgg

Market Demand

0

2

4

6

8

10

12

0 2 4 6 8 10

(D1)

0

2

4

6

8

10

12

0 1 2 3 4 5

(D2)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

0 2 4 6 8 10 12 14

D

Market Demand

Price Elasticity of Demand.

◦ A percentage change in the quantity of a good

demanded that results from a 1% change in its

own price.

◦ or

Market Demand.

Elasticity of Demand.Cases Elasticity Implication

η = 0 Perfectly Inelastic Any change in price will leave the

quantity demanded unchanged.

0 < η < 1 Inelastic Less sensitive to a change in price an

increase in price will increase total

expenditure.

η = 1 Unit Elastic A 1% change in price will result in 1%

change in quantity.

1 < η < Infinity Elastic More sensitive to a change in price a

decrease in price will increase total

expenditure.

η = Infinity Perfectly Elastic A small change in price results in 0

quantity demanded.

Market Demand.

Concept of Income Elasticity of Demand.

◦ A percentage change in the quantity of a good

demanded that results from a 1% change in

one’s income.

Q I

I Q

Market Demand

Concept of Cross Price Elasticity of

Demand.

◦ A percentage change in the quantity of a good

demanded that results from a 1% change in

another good’s price.

◦ X > 0 => Good X and Y are substitute.

◦ X < 0 => Good X and Y are complement.

X YX

Y X

Q P

P Q

Market Demand

Exercise:

◦ A hot dog vendor faces a market consisting of

30 identical individuals, each has a demand for

hot dog as:

Derive the agg. Market demand for hotdog?

If the vendor has been selling 300 hot dogs/day, how

much revenue has he been collecting?

What is the price elasticity of demand at this level

of sales?

If the vendor wants to increase his daily revenue,

should he raise or lower the price?

At what price would he max. total revenue?

160

2iq P