chapter 4 › ~leesang › 301 › chlee04.pdf · income and substitution effects: normal good food...

Chapter 4

Individual and Market Demand

2

Topics to be Discussed

Individual Demand

Income and Substitution Effects

Market Demand

Consumer Surplus

Network Externalities

Empirical Estimation of Demand

3

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

4


The Price-Consumption Curve traces out the utility maximizing market

basket for each price of food

4

U2

B

12 20

5

U3

D


Clothing

6 A

U1

4

10

5


By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individualFrom the previous example:

Demand Schedule

20$0.50

12$1.00

4$2.00

QP

6



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

7

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 otherTwo goods are considered complementsif an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other

8

Substitutes & Complements

If the price consumption curve is downward-sloping, the two goods are considered substitutesIf the price consumption curve is upward-sloping, the two goods are considered complementsThey could be both

9

Individual Demand

Income ChangesUsing the figures developed in the previous chapter, the impact of a change in the income can be illustrated using indifference curvesChanging income, with prices fixed, causes consumers to change their market baskets

10

Effects of Income Changes


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

BU2

D7

16

U3

Assume: Pf = $1, Pc = $2I = $10, $20, $30

11



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

BU2

D7

16

U3

Income Consumption Curve

12



Priceof

foodAn 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

13

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...

14

Individual Demand

Engel CurvesEngel curves relate the quantity of good consumed to incomeIf the good is a normal good, the Engel curve is upward slopingIf the good is an inferior good, the Engel curve is downward sloping

15

Engel Curves

Food (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16

Engel curves slopeupward for

normal goods.

16

Engel Curves

Engel curves arebackward bendingfor inferior goods.

Inferior

Normal

Food (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16

17

Annual US Household Consumer Expenditures

18


A change in the price of a good has two effects:

Substitution EffectIncome Effect

19


Substitution EffectConsumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive.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 constantWhen the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good

20


Income EffectConsumers experience an increase in real purchasing power when the price of one good fallsThe 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 constantWhen a person’s income increases, the quantity demanded for the product may increase or decrease

21

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.

22

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

23


A Special Case: The Giffen GoodThe income effect may theoretically be large enough to cause the demand curve for a good to slope upwardThis rarely occurs and is of little practical interest

24

Market Demand

Market Demand CurvesA curve that relates the quantity of a good that all consumers in a market buy to the price of that goodThe sum of all the individual demand curves in the market

25

Determining the Market Demand Curve

64205

117404

1810623

2513842

32161061

Market DemandCBAPrice

26

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

27

Market Demand

Aggregation is important to be able to discuss regarding demand for different groups

Households with childrenConsumers aged 20 – 30, etc.

28

Market Demand

Price Elasticity of DemandMeasures the percentage change in the quantity demanded resulting from a percent change in price

QP

PQ

P/PQ/Q

P%Q% EP

∆∆

=∆∆

=∆∆

=

29

Price Elasticity of Demand

Inelastic DemandEp is less than 1 in absolute valueQuantity demanded is relatively unresponsive to a change in price|%∆Q| < |%∆P|Total expenditure (P*Q) increases when price increases

30


Elastic DemandEp is greater than than 1 in absolute valueQuantity demanded is relatively responsive to a change in price|%∆Q| > |%∆P|Total expenditure (P*Q) decreases when price increases

31


Isoelastic DemandWhen price elasticity of demand is constant along the entire demand curveDemand curve is bowed inward (not linear)

32

The Aggregate Demand for Wheat

The demand for US wheat is comprised of two components: domestic demand export demandThe domestic demand for wheat is given by the equation:

QDD = 1465 - 88PThe export demand for wheat is given by the equation:

QDE = 1344 - 138P

33


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

34

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


Wheat

Price

0

10

16

18

Above C, export demand is zero, so domestic demand = total demand = AE segment

35

Consumer Surplus

Consumers buy goods because it makes them better offConsumer Surplus measures how much better off they are

36

Consumer Surplus

Consumer SurplusConsumers buy goods because it makes them better off The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paidCan calculate consumer surplus from the demand curve

37

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 surplusCan measure this for each ticketTotal surplus is addition of surplus for each ticket purchased

38

Demand Curve

ConsumerSurplus

Consumer Surplusfor the Market Demand

Consumer Surplus

Rock Concert Tickets

Price($ perticket)

2 3 4 5 6

13

0 1

ActualExpenditure

14151617181920

Market Price

CS = ½ ($20 - $14)*(1600) = $19,500

39

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

Total benefits would be compared to total costs to determine if the clean up was worthwhile

40

Applying Consumer Surplus –An Example

The Value of Clean AirAir is free in the sense that we don’t pay to breathe itThe Clean Air Act was amended in 1970Question: Were the benefits of cleaning up the air worth the costs?

41

The Value of Clean Air

Empirical data determined estimates for the demand for clean airNo 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

42

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

43


Up to this point we have assumed that people’s demands for a good are independent of one anotherFor some goods, one person’s demand also depends on the demands of other peopleIf this is the case, a network externalityexists

44


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

45


The Bandwagon EffectThis is the desire to be in style, to have a good because almost everyone else has it, or to indulge in a fadThis 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

46

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

47

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

48


The Snob EffectIf the network externality is negative, a snob effect exists

The snob effect refers to the desire to own exclusive or unique goodsThe quantity demanded of a “snob” good is higher the fewer the people who own it

49

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 longlines at the ski lift.

Net Effect Snob Effect

50


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 priceProblem

Consumers may lack information or interest, or be misled by the interviewer

51


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

52

Demand Data for Raspberries

53

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

54


Substitutes: b2 is positiveComplements: b2 is negative

)log(log)log()log( 22 IcPbPbaQ ++−=

Complements and Substitutes

55

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

chapter 4 › ~leesang › 301 › chlee04.pdf · income and substitution effects: normal good food...

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