Individual and Market Demand

Chapter 4

1

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.For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves

2

5

U3

D

6 A

U1

4

10

4

U2

B

12 20

Clothing

Food (units per month)

Assume: •I = $20•PC = $2•PF = $2, $1, $0.50

Each price leads to different amounts of

food purchased

3

Effect of a Price Change

● price-consumption curve: Curve tracing the utility-maximizing combinations of two goods as the price of one changes.

individual demand curve: Curve relating the quantity of a good that a single consumer will buy to its price.

4

Effect of a Price Change

• By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual

• From the previous example:

Demand Schedule

P Q

$2.00 20

$1.00 12

$0.50 4

5

Effect of a Price Change

Food (units per month)

Priceof Food

Demand Curve

H

E

G

$2.00

4 12 20

$1.00

$.50

Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.

6

Demand Curves – Important Properties

• The level of utility that can be attained changes as we move along the curve.

• 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

7

Effect of a Price Change

H

E

G

$2.00

4 12 20

$1.00

$.50

Food (units per month)

Priceof Food

Demand Curve

When the price falls: Pf/Pc & MRS also fall

•E: Pf/Pc = 2/2 = 1 = MRS•G: Pf/Pc = 1/2 = .5 = MRS•H:Pf/Pc = .5/2 = .25 = MRS

8

Effects of Income Changes

D7

16

U3

5

10

B

U2

3

4

A U1

Clothing(units per

month)

Food (units per month)

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

An increase in income,with the prices fixed,

causes consumers to altertheir choice ofmarket basket.

9

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.

– 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

10

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.

11

Engel Curves

Food (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16

Engel curves slopeupward for

normal goods.

12

Substitutes & Complements

• Two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other.Ex: movie tickets and video rentals

• Two goods are complements if an increase in the price of one good leads to a decrease in the quantity demanded of the other.Ex: gasoline and motor oil

• Two goods are independent if a change in the price of one good has no effect on the quantity demanded of the otherEx: chicken and airplane tickets

13

Substitutes & Complements

• A change in the price of a good has two effects: – Substitution Effect– Income Effect

14

Income and Substitution Effects

• Substitution Effect– Relative price of a good changes when price

changes– Consumers will tend to buy more of the good that

has become relatively cheaper, and less of the good that is relatively more expensive.

• Income Effect– Consumers experience an increase in real

purchasing power when the price of one good falls.

15

• 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 demanded of the good.

• 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.

– Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.

16

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.

R

F1 S

C1 A

U1

The income effect, EF2, ( from D to B) keeps relativeprices constant but increases purchasing power.

Income Effect

Food (units per month)

Clothing(units per

month)

Income and Substitution Effects: Normal Good

17

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

U1

SubstitutionEffect

F1 E F2S

Clothing(units per

month)

Food (units per month)

R

Income and Substitution Effects: Inferior Good

18

Market Demand

• Price Elasticity of Demand– Measures the percentage change in the

quantity demanded resulting from a percent change in price.

Q

P

P

Q

P/P

Q/Q

P%

Q% EP

19

Market Demand

Inelastic Demand

Ep is less than 1 in absolute value

Quantity demanded is relative unresponsive to a change in price%Q < %P

Total expenditure (P*Q) increases when price increases

20

Market Demand

Elastic Demand

Ep is greater than than 1 in absolute valueQuantity demanded is relative responsive to a change in price

%Q > %P

Total expenditure (P*Q) decreases when price increases

21

Price Elasticity of Demand

• Isoelastic Demand– When price elasticity of demand is constant

along the entire demand curve– Demand curve is bowed inward (not linear)

22

Example

Domestic demand for wheat is given by the equation

QDD = 1430 – 55P

where QDD is the number of bushels (in millions) demanded domestically, and P is the price in dollars per bushel. Export demand is given by

QDE = 1470 − 70P

where QDE is the number of bushels (in millions) demanded from abroad.

To obtain the world demand for wheat, we set the left side of each demand equation equal to the quantity of wheat. Wethen add the right side of the equations, obtaining

QDD + QDE = (1430 − 55P) + (1470 − 70P) = 2900 − 125P 23

Consumer Surplus

• Consumers buy goods because it makes them better off

• Consumer Surplus measures how much better off they are– The difference between the maximum amount

a consumer is willing to pay for a good and the amount actually paid.

– Can calculate consumer surplus from the demand curve

24

Consumer Surplus

Demand Curve

ActualExpenditure

Market Price

2 3 4 5 60 1

14

15

16

17

18

19

20Consumer Surplus

for the Market Demand

CS = ½ ($20 - $14)*(1600) = $19,500

Price ($ perticket)

Rock Concert Tickets25

Empirical Estimation of Demand

• Estimating Elasticities– For the demand equation: Q = a - bP

• Elasticity:

)/()/)(/( QPbQPPQEP

Assuming: Price & income elasticity are constant– The isoelastic demand =

)log()log()log( IcPbaQ The slope, -b = price elasticity of demandConstant, c = income elasticity of demand

26

Using the Raspberry data:

)log(46.1)log(4.281.0)log( IPQ

Price elasticity = -0.24 (Inelastic)Income elasticity = 1.46

)log(log)log()log( 22 IcPbPbaQ

• Substitutes: b2 is positive• Complements: b2 is negative

27

)log(14.0)log(62.0)log(085.2998.1)log( SWGNGN PIPQ

Price elasticity = -2.0Income elasticity = 0.62Cross elasticity = 0.14

28