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Chapter 4

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

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Chapter 4

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  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 consumer’s 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 consumer’s 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 consumer’s 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) 0 4 8 12 16

  36. Engel Curves Income ($ per month) 30 Engel curves slope upward for normal goods. 20 10 Food (units per month) 0 4 8 12 16

  37. Engel Curves Income ($ per month) 30 20 10 Hamburger (units per month) 0 5 10

  38. Engel Curves Income ($ per month) 30 Engel curves slope backward bending for inferior goods. 20 10 Hamburger (units per month) 0 5 10

  39. Engel Curves Income ($ per month) 30 Inferior Engel curves slope backward bending for inferior goods. 20 Normal 10 Hamburger (units per month) 0 5 10

  40. Example: Consume Expenditures in the United States Income Group (1993 $) Entertainment 520 894 1,185 1,602 2,018 2,565 4,007 Owned Dwellings 854 1,370 2,122 3,314 4,450 5,616 9,736 Rented Dwellings 1,642 2,128 1,978 1,884 1,802 1,514 748 Health Care 1,034 1,647 1,732 1,881 2,012 2,054 2,703 Food 2,461 3,198 3,971 4,706 5,556 6,273 8,137 Clothing 867 1,068 1,394 1,778 2,215 2,316 3,668 Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above

  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 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.

  46. 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

  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 E S F2 T Total Effect

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