Chapter 4 individual and market demand

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. Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U2
U3
A
B
DU1
4 12 20
Three separate
indifference curves
are tangent to
each budget line.
Assume:
•I = $20
•PC = $2
•PF = $2, $1, $.50
10

6. Price-Consumption Curve
Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U2
U3
A
B
DU1
4 12 20
The price-consumption
curve traces out the
utility maximizing
market basket for the
various prices for food.

7. Effect of a Price Change
Demand Curve
Individual Demand relates
the quantity of a good that
a consumer will buy to the
price of that good.
Food (units
per month)
Price
of Food
H
E
G
$2.00
4 12 20
$1.00
$.50

8. Individual Demand
 Two Important Properties of Demand
Curves
1) The level of utility that can be
attained changes as we move
along the curve.
The Individual Demand CurveThe Individual Demand Curve

9. 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.
The Individual Demand CurveThe Individual Demand Curve

10. Effect of a Price Change
Food (units
per month)
Price
of Food
H
E
G
$2.00
4 12 20
$1.00
$.50
Demand 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

11. 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.

12. 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.
Income-Consumption
Curve
3
4
A U1
5
10
B
U2
D7
16
U3
Assume: Pf = $1
Pc = $2
I = $10, $20, $30

13. Effects of Income Changes
Food (units
per month)
Price
of
food
An increase in income,
from $10 to $20 to $30,
with the prices fixed,
shifts the consumer’s
demand curve to the right.
$1.00
4
D1
E
10
D2
G
16
D3
H

14. Individual Demand
 Income Changes
The income-consumption curve traces
out the utility-maximizing combinations
of food and clothing associated with
every income level.

15. 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.

16. Individual Demand
 Income Changes
When the income-consumption curve
has a positive slope:
 The quantity demanded increases
with income.
 The income elasticity of demand is
positive.
 The good is a normal good.
Normal Good vs. Inferior GoodNormal Good vs. Inferior Good

17. Individual Demand
 Income Changes
When the income-consumption curve
has a negative slope:
 The quantity demanded decreases
with income.
 The income elasticity of demand is
negative.
 The good is an inferior good.
Normal Good vs. Inferior GoodNormal Good vs. Inferior Good

18. An Inferior Good
Hamburger
(units per month)
Steak
(units per
month)
15
30
U3
C
Income-Consumption
Curve
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C.
105 20
5
10
A
U1
B
U2
Both hamburger
and steak behave
as a normal good,
between A and B...

19. 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.

20. Engel Curves
Food (units
per month)
30
4 8 12
10
Income
($ per
month)
20
160
Engel curves slope
upward for
normal goods.

21. Engel Curves
Engel curves slope
backward bending
for inferior goods.
Inferior
Normal
Food (units
per month)
30
4 8 12
10
Income
($ per
month)
20
160

22. Consumer Expenditures
in the United States
Entertainment 700 947 1274 1514 2054 2654 4300
Owned Dwellings1116 1725 2253 3243 4454 5793 9898
Rented Dwellings1957 2170 2371 2536 2137 1540 1266
Health Care 1031 1697 1918 1820 2052 2214 2642
Food 2656 3385 4109 4888 5429 6220 8279
Clothing 859 978 1363 1772 1778 2614 3442
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 (1997 $)

23. Individual Demand
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. movie tickets and video rentals
Substitutes and ComplementsSubstitutes and Complements

24. Individual Demand
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. gasoline and motor oil
Substitutes and ComplementsSubstitutes and Complements

25. Individual Demand
3) Two goods are independent when a
change in the price of one good has
no effect on the quantity demanded
of the other
Substitutes and ComplementsSubstitutes and Complements

26. 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!

27. Income and Substitution Effects
 A fall in the price of a good has two
effects: Substitution & Income
Substitution Effect
 Consumers will tend to buy more of
the good that has become relatively
cheaper, and less of the good that is
now relatively more expensive.

28. Income and Substitution Effects
 A fall in the price of a good has two
effects: Substitution & Income
Income Effect
 Consumers experience an increase
in real purchasing power when the
price of one good falls.

29. 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.

30. 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.

31. Income and Substitution Effects
 Income Effect
Even with inferior goods, the income
effect is rarely large enough to outweigh
the substitution effect.

32. Income and Substitution
Effects: 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 relative
prices 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
Substitution
Effect
D
The substitution effect,F1E,
(from point A to D), changes the
relative prices but keeps real income
(satisfaction) constant.

33. Food (units
per month)
O
R
Clothing
(units per
month)
F1 S F2 T
A
U1
E
Substitution
Effect
D
Total Effect
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.
B
Income Effect
U2
Income and Substitution
Effects: Inferior Good

34. 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.

35. Effect of a Gasoline Tax With a Rebate
 Assume
Pe
d
= -0.5
Income = $9,000
Price of gasoline = $1

36. Effect of a Gasoline Tax With a Rebate
Gasoline Consumption
(gallons/year)
Expenditures
On Other
Goods ($)
A
C •Gasoline = 1200 gallons
•Other expenditures = $7800
U2
1200
Original Budget
Line
BD
U1
900
After
Gasoline
Tax
E
•$.50 Excise Tax
•Gasoline = 900 gallons
J
F
H
913.5
After Gasoline Tax
Plus Rebate
U3
•$450 REBATE
•New budget line
•Consumer is worse off

37. 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.
From Individual to Market DemandFrom Individual to Market Demand

38. Determining the
Market Demand Curve
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
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)

39. Summing to Obtain a
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DB DC
Market Demand
DA
The market demand
curve is obtained by
summing the consumer’s
demand curves

40. 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.

41. Market Demand
 Elasticity of Demand
Recall: Price elasticity of demand
measures the percentage change in the
quantity demanded resulting from a
1-percent change in price.
PQ
PQ
P/P
Q/Q
EP
/
/ ∆∆
=
∆
∆
=

42. Price Elasticity and
Consumer Expenditure
Demand If Price Increases, If Price Decreases,
Expenditures: Expenditures:
Inelastic (Ep <1) Increase Decrease
Unit Elastic (Ep = 1) Are unchanged Are unchanged
Elastic (Ep >1) Decrease Increase

43. Market Demand
 Point Elasticity 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.

44. Market Demand
 Point Elasticity of Demand
Point elasticity measures elasticity at a
point on the demand curve.
Its formula is:
ope)(P/Q)(1/slEP =

45. Market Demand
 Problems Using Point Elasticity
We may need to calculate price
elasticity over portion of the demand
curve rather than at a single point.
The price and quantity used as the base
will alter the price elasticity of demand.

46. Market Demand
 Assume
 Price increases from 8$ to $10 quantity
demanded falls from 6 to 4
 Percent change in price equals:
$2/$8 = 25% or $2/$10 = 20%
 Percent change in quantity equals:
-2/6 = -33.33% or -2/4 = -50%
Point Elasticity of Demand (An Example)Point Elasticity of Demand (An Example)

47. Market Demand
 Elasticity equals:
-33.33/.25 = -1.33 or -.50/.20 = -2.54
 Which one is correct?
Point Elasticity of Demand (An Example)Point Elasticity of Demand (An Example)

48. Market Demand
 Arc Elasticity of Demand
Arc elasticity calculates elasticity over a
range of prices
Its formula is:
e quantitythe averagQ
e pricethe averagP
QPP)(Q/(EP
=
=
∆∆= )/

49. Market Demand
 Arc Elasticity of Demand (An Example)
8.1)5/9)($2$/2(
52/10&92/18
4,6,10,8
)/
2121
−=−=
====
====
∆∆=
pE
QP
QQPP
QPP)(Q/(EP

50. The Aggregate Demand For Wheat
 The demand for U.S. wheat is
comprised of domestic demand and
export demand.
An Example:

51. The Aggregate Demand For Wheat
 The domestic demand for wheat is
given by the equation:
QDD = 1700 - 107P
 The export demand for wheat is
given by the equation:
QDE = 1544 - 176P

52. The Aggregate Demand For Wheat
 Domestic demand is relatively price
inelastic (-0.2), while export demand
is more price elastic (-0.4).

53. C
D
Export
Demand
A
B
Domestic
Demand
Total world demand is
the horizontal sum of the
domestic demand AB and
export demand CD.
F
Total Demand
E
The Aggregate Demand For Wheat
Wheat(million bushels/yr.)
Price
($/bushel)
0
2
4
6
8
10
12
14
16
18
20
1000 2000 3000 4000

54. Consumer Surplus
 Consumer Surplus
The difference between the maximum
amount a consumer is willing to pay for
a good and the amount actually paid.

55. The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 =
21
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

56. Consumer Surplus
 The stepladder demand curve can
be converted into a straight-line
demand curve by making the units of
the good smaller.

57. Demand Curve
Consumer
Surplus
Actual
Expenditure
$19,50014)x6,5001/2x(20 =−
Consumer Surplus
for the Market Demand
Consumer Surplus
Rock Concert Tickets
Price
($ per
ticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price

58. 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

59. 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?
An Example:

60. 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.

61. 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 $1000 per
part reduced.
Valuing Cleaner Air
2000
100
1000
5
A
NOX (pphm)
Pollution Reduction
Value
($ per pphm
of reduction)

62. Network Externalities
 Up to this point we have assumed
that people’s demands for a good
are independent of one another.
 If fact, a person’s demand may be
affected by the number of other
people who have purchased the
good.

63. Network Externalities
 If this is the case, a network
externality exists.
 Network externalities can be positive
or negative.

64. 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.

65. 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).

66. Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D20
20 40
When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right .
D40
60
D60
80
D80
100
D100

67. Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D20
20 40 60 80 100
D40 D60 D80 D100 The market demand
curve is found by joining
the points on the individual
demand curves. It is relatively
more elastic.

68. Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D20
20 40 60 80 100
D40 D60 D80 D100
Pure Price
Effect
48
Suppose the price falls
from $30 to $20. If there
were no bandwagon effect,
quantity demanded would
only increase to 48,000
$20
$30

69. Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D20
20 40 60 80 100
D40 D60 D80 D100
Pure Price
Effect
$20
48
Bandwagon
Effect
But as more people buy
the good, it becomes
stylish to own it and
the quantity demanded
increases further.$30

70. 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.

71. Negative Network
Externality: Snob Effect
Quantity (thousands
per month)
Price
($ per
unit) Demand
2
D2
$30,000
$15,000
14
Pure Price Effect
Originally demand is D2,
when consumers think 2000
people have bought a good.
4 6 8
D4
D6
D8
However, if consumers think 4,000
people have bought the good,
demand shifts from D2 to D6 and its
snob value has been reduced.

72. Negative Network
Externality: Snob Effect
Quantity (thousands
per month)2 4 6 8
The demand is less elastic and
as a snob good its value is greatly
reduced if more people own
it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.
Price
($ per
unit)
D2
$30,000
$15,000
14
D4
D6
D8
Demand
Pure Price Effect
Snob Effect
Net Effect

73. Network Externalities and the Demands
for Computers and Fax Machines
 Examples of Positive Feedback
Externalities
Mainframe computers: 1954 - 1965
Microsoft Windows PC operating
system
Fax-machines and e-mail

74. 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.

75. Empirical Estimation of Demand
 Problem
Consumers may lack information or
interest, or be mislead by the
interviewer.

76.  In direct marketing experiments,
actual sales offers are posed to
potential customers and the
responses of customers are
observed.
Empirical Estimation of Demand

77.  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.
Empirical Estimation of Demand

78. Year Quantity (Q) Price (P) Income(I)
Demand Data for Raspberries
1988 4 24 10
1989 7 20 10
1990 8 17 10
1991 13 17 17
1992 16 10 17
1993 15 15 17
1994 19 12 20
1995 20 9 20
1996 22 5 20

79.  Assuming only price determines
demand:
Q = a - bP
Q = 28.2 -1.00P
Empirical Estimation of Demand

80. Estimating Demand
Quantity
Price
0 5 10 15 20 25
15
10
5
25
20
d1
d2
d3
D
D represents demand
if only P determines
demand and then from
the data: Q=28.2-1.00P

81. Estimating Demand
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
Adjusting for changes in income

82.  For the demand equation: Q = a - bP
 Elasticity:
Empirical Estimation of Demand
Estimating ElasticitiesEstimating Elasticities
)/()/)(/( QPbQPPQEP −=∆∆=

83.  Assuming: Price & income elasticity
are constant
The isoelastic demand =
The slope, -b = price elasticity of demand
Constant, c = income elasticity
Empirical Estimation of Demand
Estimating ElasticitiesEstimating Elasticities
)log()log()log( IcPbaQ +−=

84.  Using the Raspberry data:
Price elasticity = -0.24 (Inelastic)
Income elasticity = 1.46
Empirical Estimation of Demand
Estimating ElasticitiesEstimating Elasticities
)log(46.1)log(4.281.0)log( IPQ +−−=

85.  Substitutes: b2 is positive
 Complements: b2 is negative
Empirical Estimation of Demand
Estimating Complements and SubstitutesEstimating Complements and Substitutes
)log(log)log()log( 22 IcPbPbaQ ++−=

86.  What Do You Think?
Are Grape Nuts & Spoon Size
Shredded Wheat good substitutes?
The Demand for Ready-to-Eat Cereal

87.  Answer
Estimated demand for Grape Nuts (GN)
 Price elasticity = -2.0
 Income elasticity = 0.62
 Cross elasticity = 0.14
The Demand for Ready-to-Eat Cereal
) log(014. ) log(62.0 ) log(085.2 998.1 ) log(SW GN GNP I P a Q+ + − =

88. Summary
 Individual consumers’ demand
curves for a commodity can be
derived from information about their
tastes for all goods and services and
from their budget constraints.
 Engel curves describe the
relationship between the quantity of a
good consumed and income.

89. Summary
 Two goods are substitutes if an
increase in the price of one good
leads to an increase in the quantity
demanded of the other. They are
complements if the quantity
demanded of the other declines.

90. Summary
 Two goods are substitutes if an increase
in the price of one good leads to an
increase in the quantity demanded of the
other. They are complements if the
quantity demanded of the other declines.
 The effect of a price change on the
quantity demanded can be broken into a
substitution effect and an income effect.

91. Summary
 The market demand curve is the
horizontal summation of the
individual demand curves for all
consumers.
 The percent change in quantity
demanded that results from a one
percent change in price determines
elasticity of demand.

92. Summary
 There is a network externality when
one person’s demand is affected
directly by the purchasing decisions
of other consumers.
 A number of methods can be used to
obtain information about consumer
demand.

93. End of Chapter 4
Individual and
Market Demand