1

Chapters 4: Individual and Market Demand

2

Price-Consumption Curve

10 20

32

P=$2P=$3P=$7

7

3

2

10 20

Price

Quantity of butter

butter

margarine

Demand for butter

32

Price-Consumptioncurve

3

Link Between Indifference Curve Budget Constraint Model and Demand Curve

• The utility-maximizing quantities at each price level trace out the individual’s demand curve

P=$5P=$10P=$15

$5

$10

$15

9 12 15 9 12

15Q Q

P

4

From Individual to Market Demand

• Market demand is made up of the sum of individual demands

D1 D2 D3

D4

Total Demand

15 30 25 1080

p p p p p

Q Q Q Q Q

5

Income-Consumption and Engel Curves

apples

OrangesIncome

apples

I = 75I = 100

I = 50

1000 2000 2900

50

75

100

1000 2000 2900

Income-ConsumptionCurve

Engel Curve

6

Normal and Inferior Goods

• Normal good - one whose quantity demanded rises as income rises

• Inferior good - one whose quantity demanded falls as income rises

Normal good

Inferior goodNormal good

Normal good

7

Effect of a Price Change on Utility

• Compensating Variation: The minimum change in income at the new prices that would make the consumer as well off as they were before the price change

• Equivalent Variation: The minimum change in income at the old prices that would make the consumer as well off as they are after the price change

8

Compensating Variation

Compensating Variation

9

Equivalent Variation

Equivalent Variation

10

Income and Substitution Effects

• The total impact of a price change on the demand for a product can be broken into the income and substitution effects– Income effect - the component of the total effect of a price change that results from the associated change in real purchasing power (quasi income)

– Substitution effect - the component of the total effect of a price change that results from the associated change in the relative attractiveness (relative price) of the good in question

• Giffen good is one for which the total effect of a price increase/decrease is to increase/decrease the demand for that good (counter intuitive effect)– Substitution effect is always in the same direction so a Giffen good is a strongly inferior good, so strongly inferior that the income effect is larger than the substitution effect

11

Effect of a Price Change: Normal Good

apples

All other goods

Income effect

Substitution effect

12

Effect of a Price Change: Inferior Good

Spam

All other goods

Income effectSubstitution

effect

13

Effect of a Price Change: Giffen Good

Potatoes

All other goods

Income effect

Substitution effect

14

Price Elasticity

• Price elasticity of demand - the percentage change in the quantity demanded that results from a 1 percent change in its price

• Always less than zero by Law of Demand

• The value of price elasticity tells whether demand is elastic, inelastic, or unitary elastic– Elastic– Inelastic– Unitary Elastic

%Q%P

QP

P

Q

1

slope

P

Q 0

1

1

1

15

Graphical Depiction of Price Elasticity

10

9

2

1

1 2 9 10

1 QP

P

Q(2 1)(9 10)

9

29

2

2 QP

P

Q(10 9)(1 2)

2

92

9

Elastic

Inelastic

Price

Quantity

demand

16

Elasticity Along a Demand Curve

Elastic

Inelastic

Price

Quantity

demand

Unitary Elastic

17

Other Elasticities

• Income elasticity of demand - the percentage change in the quantity demanded that results from a 1 percent change in income (Y)

• Cross-price elasticity - the percentage change in the demand for good X that results from a 1 percent change in the price of good Y

%Q%Y

QYY

Q

xy %Qx%Py

QxPy

PyQx

18

What Determines Price Elasticities

• Substitution possibilities - greater number of substitutes makes goods more elastic

• Budget share - greater share of expenditures accounted for by the product, the more elastic

• Direction of income effect - normal goods will have higher price elasticities than inferior goods b/c the income effect reinforces the substitution effect

• Time - the longer the time period in question, the greater the price elasticity

19

Price Elasticity and Total Revenue(Elastic)

Price

Quantity

Gains in total revenue from lowering the price

Losses in total revenue from lowering the price

20

Price Elasticity and Total Revenue

(Inelastic)Price

Quantity

Gains in total revenue from lowering the price

Losses in total revenue from lowering the price