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
Food (units
per month)
Clothing
(units per
month)
7. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
The budget lines
illustrate three
prices for
food--$2
$2
8. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
The budget lines
illustrate three
prices for
food--$2, $1,
$2 $1
9. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
The budget lines
illustrate three
prices for
food--$2, $1,
and $.50
$2 $1 $0.50
10. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
A
U2
U3
B
D
U1
Three separate
indifference curves
are tangent to
each budget line.
11. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U2
U3
A
B
D
U1
4 12 20
Three separate
indifference curves
are tangent to
each budget line.
12. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U2
U3
Price-Consumption Curve
B
D
A
U1
4 12 20
The price-consumption
curve traces out the
utility maximizing
market basket for the
various prices for food.
13. Effect of a Price Change
Food (units
per month)
Price
of Food
$2.00
$1.50
$1.00
$.50
4 12 20
Demand Curve
E
G
H
The points E, G, and H
correspond to points
A, B, and D,
respectively.
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
Food (units
per month)
3
7
4 10 16
5
Clothing
(units per
month)
18. Effects of Income Changes
Food (units
per month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
3
7
4 10 16
5
A U1
Clothing
(units per
month)
19. Effects of Income Changes
Food (units
per month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
3
7
4 10 16
5
A U1
B
U2
Clothing
(units per
month)
20. Effects of Income Changes
Food (units
per month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
3
7
4 10 16
5
A U1
B
U2
D
U3
Clothing
(units per
month)
21. Effects of Income Changes
Food (units
per month)
Clothing
(units per
month)
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
3
7
4 10 16
5
Income-Consumption
Curve
A U1
B
U2
D
U3
22. Effects of Income Changes
Food (units
per month)
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.
$1.00
4 10 16
D1
E
23. Effects of Income Changes
Food (units
per month)
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.
$1.00
4 10 16
D1
D2
E G
24. Effects of Income Changes
Food (units
per month)
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.
$1.00
4 10 16
D1
D2
D3
E G H
25. Individual Demand
Income Changes
• The income-consumption curve traces out the
utility-maximizing combinations of food and
clothing associated with every income level.
26. Individual Demand
Income Changes
• An increase in income shifts the budget line to
the right, increasing consumption along the
income-consumption curve.
• Simultaneously, the increase in income shifts
the demand curve to the right.
27. Individual Demand
Income Changes
• If the income-consumption curve has a positive
slope, the quantity demanded increases with
income and the income elasticity of demand is
positive.
• The good is a normal good.
28. Individual Demand
Income Changes
• If the income-consumption curve has a negative
slope, the quantity demanded decreases with
income and the income elasticity of demand is
negative.
• The good is an inferior good.
31. An Inferior Good
Hamburger
(units per month)
15
5 10 20
5
Steak
(units per
month)
10
30
A
U1
B
U2
Both hamburger
and steak behave
as a normal good,
between A and B...
32. An Inferior Good
Hamburger
(units per month)
15
5 10 20
5
Steak
(units per
month)
10
30
A
U1
B
U2
U3
C
…but hamburger
becomes and inferior
good when the income
consumption curve
bends backward
between B and C.
33. An Inferior Good
Hamburger
(units per month)
15
5 10 20
5
Steak
(units per
month)
10
30
A
B
U1
B
U2
U3
C
Income-Consumption
Curve
…but hamburger
becomes and inferior
good when the income
consumption curve
bends backward
between B and C.
34. Individual Demand
Engel Curves
• Engel curves relate the quantity of good
consumed to income.
• If the good is a normal good, the Engel curve is
upward sloping.
• If the good is an inferior good, the Engel curve
is downward sloping.
38. Engel Curves
Hamburger
(units per month)
30
5 10
10
Income
($ per
month)
20
Engel curves slope
backward bending
for inferior goods.
0
39. Engel Curves
Hamburger
(units per month)
30
5 10
10
Income
($ per
month)
20
Engel curves slope
backward bending
for inferior goods.
0
Inferior
Normal
40. 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 $)
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
Food (units
per month)
O
R
Clothing
(units per
month)
F1 S
C1
Originally, the
consumer is at A
on budget line RS.
A
U1
49. Income and Substitution Effects--
Normal Good
Food (units
per month)
O
R
Clothing
(units per
month)
C2
F1 S F2 T
C1
A
U1
When the price of food
falls, consumption
increases by F1Fs as
the consumer
moves to B.
U2
B
50. Income and Substitution Effects--
Normal Good
Food (units
per month)
O
R
Clothing
(units per
month)
C2
F1 S F2 T
C1
A
U1
U2
B
E
Total Effect
Substitution
Effect
The substitution effect,F1E,
(from points AD),
changes the relative prices
but keeps real income
constant.
D
51. Income and Substitution Effects--
Normal Good
Food (units
per month)
O
R
Clothing
(units per
month)
C2
F1 S F2 T
C1
A
U1
The income effect, EF2,
(D to B) keeps relative
prices constant but
increases purchasing power.
U2
B
E
Total Effect
Substitution
Effect
Income Effect
D
52. Income and Substitution Effects--
Inferior Good
Food (units
per month)
O
R
Clothing
(units per
month)
F1 S
Originally, the
consumer is at A
on budget line RS.
A
U1
53. Income and Substitution Effects--
Inferior Good
Food (units
per month)
O
R
Clothing
(units per
month)
F1 S T
A
U1
E
Substitution
Effect
The substitution effect,F1E,
(from points AD),
changes the relative prices
but keeps real income
constant.
D
54. Income and Substitution Effects--
Inferior Good
Since food is an
inferior good, the
income 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
Substitution
Effect
D
B
Income Effect
U2
55. 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.
56. Market Demand
From Individual to Market Demand
• Market demand curves are the horizontal
summation of the individuals’ demand curves.
58. Summing to Obtain a
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
D
A
The market demand
curve is obtained by
summing the consumer’s
demand curves
59. Summing to Obtain a
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
D
A
DB
The market demand
curve is obtained by
summing the consumer’s
demand curves
60. Summing to Obtain a
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
D
A
DB D
C
The market demand
curve is obtained by
summing the consumer’s
demand curves
61. Summing to Obtain a
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
D
A
DB D
C
Market Demand
The market demand
curve is obtained by
summing the consumer’s
demand curves
62. 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.
63. 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.
P
Q
P
Q
P/P
Q/Q
EP
/
/
64. Price Elasticity and
Consumer 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
65. 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.
66. 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
EP
67. 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.
68. 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:
)
/Q
P
P)(
Q/
(
EP
70. Example:The Aggregate
Demand 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
71. Example:The Aggregate
Demand For Wheat
Domestic demand is relatively price
inelastic (-0.2), while export demand is
more price elastic (-0.4 to -0.5).
72. The Aggregate Demand
for Wheat
Quantity (millions of bushels per year)
Price
($/bushel)
0
2
4
6
8
10
12
14
16
18
20
1000 2000 3000 4000
A
C
B D
Domestic
Demand
Export
Demand
73. The Aggregate Demand
for Wheat
Quantity (millions of bushels per year)
Price
($/bushel)
0
2
4
6
8
10
12
14
16
18
20
1000 2000 3000 4000
A
C
B D
Domestic
Demand
Export
Demand
E
F
Total Demand
Total world demand is
the horizontal sum of the
domestic demand AB and
export demand CD.
74. Consumer Surplus
Consumer surplus is the difference between
what a consumer is willing to pay for a
good and what the consumer actually pays
when buying it.
76. Consumer Surplus
Rock Concert Tickets
Price
($ per
ticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20 The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
Market Price
77. Consumer Surplus
Rock Concert Tickets
Price
($ per
ticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Consumer
Surplus
The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
78. Consumer Surplus
Rock Concert Tickets
Price
($ per
ticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20 The consumer’s
actual expenditure
is the price times
the quantity purchased.
Market Price
Actual
Expenditure
Consumer
Surplus
79. Consumer Surplus
The stepladder demand curve can be
converted into a straight-line demand curve
by making the units of the good smaller.
80. Consumer Surplus
Rock Concert Tickets
Price
($ per
ticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20 For goods that cannot
be divided into small
parts the consumer surplus
is the yellow area
below the demand curve.
Actual
Expenditure
Demand Curve
Market Price
Consumer
Surplus
81. 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
82. 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?
83. 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.
84. Valuing Clean Air
NOX (pphm)
Pollution Reduction
Value
($ per pphm
of reduction)
0
1000
2000
5 10
85. Valuing Clean Air
NOX (pphm)
Pollution Reduction
Value
($ per pphm
of reduction)
0
1000
2000
5 10
86. Valuing Clean Air
NOX (pphm)
Pollution Reduction
Value
($ per pphm
of reduction)
0
1000
2000
5 10
A
The shaded area gives the
consumer surplus generated
when air pollution is
reduced by 5 parts per 100
million of nitrous oxide at
a cost of $1000 per
part reduced.
