Ch04_Pindyck

7/31/2019 Ch04_Pindyck

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Chapter 4

Individual and Market Demand


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2005 Pearson Education, Inc. Chapter 4 2

Topics to be Discussed

Individual Demand

Income and Substitution Effects

Market Demand

Consumer Surplus

Network Externalities

Empirical Estimation of Demand


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Individual Demand

Price Changes

Using the figures developed in the previouschapter, the impact of a change in the priceof food can be illustrated using indifferencecurves

For each price change, we can determinehow much of the good the individual wouldpurchase given their budget lines andindifference curves


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Effect of a Price Change

Each price leads todifferent amounts of

food purchased5

U3

D

4

U2

B

12 20

Assume: I =$20 PC = $2

PF =$2, $1, $0.50

Food (unitsper month)

Clothing

6 A

U1

4

10


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The Price-Consumption Curvetraces out the utilitymaximizing market

basket for each priceof food

4

U2

B

12 20

5

U3

D


Clothing

6 A

U1

4

10


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By changing pricesand showing whatthe consumer will

purchase, we cancreate a demandschedule anddemand curve for the

individual From the previous

example:

Demand Schedule

P Q

$2.00 4

$1.00 12

$0.50 20


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Demand Curve

Individual Demand relatesthe quantity of a good thata consumer will buy to the

price of that good.


Priceof Food

H

E

G

$2.00

4 12 20

$1.00

$.50


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Demand Curves ImportantProperties

The level of utility that can be attainedchanges as we move along the curve

At every point on the demand curve, theconsumer is maximizing utility bysatisfying the condition that the MRS offood for clothing equals the ratio of the

prices of food and clothing


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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


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Individual Demand

Income Changes

Using the figures developed in the previouschapter, the impact of a change in theincome can be illustrated using indifferencecurves

Changing income, with prices fixed, causesconsumers to change their market baskets


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Effects of Income Changes


Clothing(units per

month)

An increase in income,with the prices fixed,causes consumers to alter

their choice ofmarket basket.

3

4

A U1

5

10

B

U2

D7

16

U3

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


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Individual Demand

Income Changes

The income-consumption curve traces outthe utility-maximizing combinations of food

and clothing associated with every incomelevel


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Individual Demand

Income Changes

An increase in income shifts the budget lineto the right, increasing consumption along

the income-consumption curve

Simultaneously, the increase in income shiftsthe demand curve to the right


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Clothing(units per

month)

The Income ConsumptionCurve traces out the utilitymaximizing market basketfor each income level

3

4

A U1

5

10

B

U2

D7

16

U3

Income ConsumptionCurve


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Priceof

food

An increase in income, from$10 to $20 to $30, with theprices fixed, shifts theconsumers demand curve

to the right as well.

$1.00

4

D1

E

10

D2

G

16

D3

H


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Individual Demand

Income Changes

When the income-consumption curve has apositive slope:

The quantity demanded increases with income

The income elasticity of demand is positive

The good is a normal good


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Individual Demand

Income Changes

When the income-consumption curve has anegative slope:

The quantity demanded decreases with income

The income elasticity of demand is negative

The good is an inferior good


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An Inferior Good

Hamburger(units per month)

Steak(units per

month)

30

U3

C

Income-ConsumptionCurve

but hamburgerbecomes an inferior

good when the incomeconsumption curve

bends backwardbetween Band C.

105

A

U1

5

20

10

B

U2

Both hamburgerand steak behaveas a normal good,between A and B...


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Engel Curves


30

10

Income($ per

month)

20

4 8 12 16

Engel curves slopeupward for

normal goods.


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Engel Curves

Engel curves arebackward bendingfor inferior goods.

Inferior

Normal


30

10

Income($ per

month)

20

4 8 12 16


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Annual US HouseholdConsumer Expenditures


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Substitutes & Complements

Two goods are considered substitutes ifan increase (decrease) in the price ofone leads to an increase (decrease) inthe quantity demanded of the other

Ex: movie tickets and video rentals


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Two goods are considered complementsif an increase (decrease) in the price ofone leads to a decrease (increase) in thequantity demanded of the other

Ex: gasoline and motor oil


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If two goods are independent, then achange in the price of one good has noeffect on the quantity demanded of theother

Ex: price of chicken and price of airplanetickets


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If the price consumption curve isdownward-sloping, the two goods areconsidered substitutes

If the price consumption curve is upward-sloping, the two goods are consideredcomplements

They could be both


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A change in the price of a good has twoeffects:

Substitution Effect

Income Effect


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Substitution Effect

Relative price of a good changes when pricechanges

Consumers will tend to buy more of the goodthat has become relatively cheaper, and lessof the good that is relatively more expensive


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Income Effect

Consumers experience an increase in realpurchasing power when the price of one

good falls


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Substitution Effect

The substitution effect is the change in anitems consumption associated with a change

in the price of the item, with the level of utilityheld constant

When the price of an item declines, thesubstitution effect always leads to an

increase in the quantity demanded of thegood


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Income Effect

The income effect is the change in an items

consumption brought about by the increase

in purchasing power, with the price of theitem held constant

When a persons income increases, the

quantity demanded for the product may

increase or decrease


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Income Effect

Even with inferior goods, the income effect israrely large enough to outweigh the

substitution effect


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O

R

Clothing(units per

month)

F1 S F2 T

A

U1

E

SubstitutionEffect

D

Total Effect

Since food is aninferior good, theincome effect is

negative. However,the substitution effect

is larger than theincome effect.

B

Income Effect

U2

Income and SubstitutionEffects: Inferior Good


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A Special Case: The Giffen Good

The income effect may theoretically be largeenough to cause the demand curve for a

good to slope upwardThis rarely occurs and is of little practical

interest


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Market Demand

Market Demand Curves

A curve that relates the quantity of a goodthat all consumers in a market buy to the

price of that goodThe sum of all the individual demand curves

in the market


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Determining the Market DemandCurve

Price A B CMarket

Demand

1 6 10 16 32

2 4 8 13 25

3 2 6 10 18

4 0 4 7 115 0 2 4 6


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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 consumers

demand curves


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Market Demand

From this analysis one can see twoimportant points:

The market demand will shift to the right asmore consumers enter the market

Factors that influence the demands of manyconsumers will also affect the marketdemand


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Market Demand

Aggregation is important to be able todiscuss regarding demand for differentgroups

Households with children

Consumers aged 20 30, etc.


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Market Demand

Price Elasticity of Demand

Measures the percentage change in thequantity demanded resulting from a percent

change in price

Q

P

P

Q

P/P

Q/Q

P%

Q%EP


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Inelastic Demand

Ep is less than 1 in absolute value

Quantity demanded is relativelyunresponsive to a change in price

|%Q| < |%P|

Total expenditure (P*Q) increases when

price increases


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Elastic Demand

Ep is greater than than 1 in absolute value

Quantity demanded is relatively responsiveto a change in price

|%Q| > |%P|

Total expenditure (P*Q) decreases when

price increases


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Price Elasticity andConsumer Expenditure


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Isoelastic Demand

When price elasticity of demand is constantalong the entire demand curve

Demand curve is bowed inward (not linear)


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The Aggregate Demand forWheat

The demand for US wheat is comprisedof two components:

Domestic demand

Export demand

Total demand for wheat can be obtainedby aggregating these two demands


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The domestic demand for wheat is givenby the equation:

QDD = 1465 - 88P

The export demand for wheat is given bythe equation:

QDE = 1344 - 138P


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Domestic demand is relatively priceinelastic (Ed = -0.2)

Export demand is more price elastic (Ed

=-0.4)

Poorer countries that import US wheat turnto other grains and food if wheat prices

increase


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C

D

ExportDemand

Total world demand isthe horizontal sum of thedomestic demand ABand

export demand CD.

F

Total Demand

A

B

DomesticDemand

E


Wheat

Price

0

10

16

18

Above C, export demand iszero, so domestic demand =total demand = AE segment


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Consumer Surplus

Consumers buy goods because it makesthem better off

Consumer Surplus measures how muchbetter off they are


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Consumer Surplus

Consumer Surplus

The difference between the maximumamount a consumer is willing to pay for a

good and the amount actually paidCan calculate consumer surplus from the

demand curve


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Consumer Surplus - Example

Student wants to buy concert tickets

Demand curve tells us willingness to payfor each concert ticket

1st ticket worth $20 but price is $14 sostudent generates $6 worth of surplus

Can measure this for each ticket

Total surplus is addition of surplus for eachticket purchased


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The consumer surplusof purchasing 6 concerttickets is the sum of the

surplus derived fromeach one individually.

Consumer Surplus6 + 5 + 4 + 3 + 2 + 1 = 21

Consumer Surplus - Example

Rock Concert Tickets

Price($ per

ticket)

2 3 4 5 6

13

0 1

14

15

1617

18

19

20

Market Price

Will not buy more than 7because surplus isnegative


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Consumer Surplus

The stepladder demand curve can beconverted into a straight-line demandcurve by making the units of the good

smaller

Consumer surplus is the area under thedemand curve and above the price


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Demand Curve

ConsumerSurplus

Consumer Surplusfor the Market Demand

Consumer Surplus

Rock Concert Tickets

Price($ per

ticket)

2 3 4 5 6

13

0 1

ActualExpenditure

14

15

1617

18

19

20

Market Price

CS = ($20 - $14)*(1600)= $19,500


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Applying Consumer Surplus

Combining consumer surplus with theaggregate profits that producers obtain,we can evaluate:

1. Costs and benefits of different marketstructures

2. Public policies that alter the behavior ofconsumers and firms


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Applying Consumer SurplusAn Example

The Value of Clean Air

Air is free in the sense that we dont pay to

breathe it

The Clean Air Act was amended in 1970

Question: Were the benefits of cleaning upthe air worth the costs?


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The Value of Clean Air

Empirical data determined estimates forthe demand for clean air

No market exists for clean air, but cansee people are willing to pay for it

Ex: People pay more to buy houses wherethe air is clean


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The Value of Cleaner Air

Using these empirical estimates, we canmeasure peoples consumer surplus for

pollution reduction from the demand

curve


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The shaded area represents theconsumer surplus generated

when air pollution isreduced by 5 parts per 100million of nitrous oxide at

a cost of $1000 perpart reduced.

Valuing Cleaner Air

2000

100

1000

5

A

NOX (pphm)Pollution Reduction

Value


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Value of Cleaner Air

A full cost-benefit analysis would includetotal benefit of cleanup

Total benefits would be compared to totalcosts to determine if the clean up wasworthwhile


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Up to this point we have assumed thatpeoples demands for a good are

independent of one another

For some goods, one persons demand

also depends on the demands of otherpeople


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If this is the case, a network externalityexists

Network externalities can be positive ornegative


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A positive network externalityexists if thequantity of a good demanded by aconsumer increases in response to an

increase in purchases by otherconsumers

Negative network externalitiesare just

the opposite


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The Bandwagon Effect

This is the desire to be in style, to have agood 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 partbecause others do

Positive Network


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Positive NetworkExternality: Bandwagon Effect

Quantity(thousands per month)

Price($ per

unit)

D20

20

When consumers believe morepeople have purchased theproduct, the demand curve shiftsfurther to the the right.

40

D40

60

D60

80

D80

100

D100

Positive Network


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Price($ per

unit)

D20

20

The market demandcurve is found by joiningthe points on the individualdemand curves. It is relativelymore elastic.

40

D40

60

D60

80

D80

100

D100

Demand

Positive Network


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Price($ per

unit)

D20

20

Suppose the price fallsfrom $30 to $20. If therewere 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 becomesstylish to own it and

the quantity demandedincreases further.

$30

48

$20

Pure PriceEffect

BandwagonEffect


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The Snob Effect

If the network externality is negative, a snobeffect exists

The snob effect refers to the desire toown exclusive or unique goods

The quantity demanded of a snob good

is higher the fewer the people who own it


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Network Externality: Snob Effect

Quantity (thousandsper month)

Price($ perunit)

2

Demand

D2

$30,000

$15,000

14

Originally demand is D2,when consumers think 2,000

people have bought a good.

4 6 8

D4D6D8

However, if consumers think 4,000

people have bought the good,demand shifts from D2 to D6 and its

snob value has been reduced.

Pure Price Effect


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Network Externality: Snob Effect

Quantity (thousandsper month)

Price($ perunit)

2

Demand

D2

$30,000

$15,000

144 6 8

D4D6D8

Pure Price Effect

The demand is less elastic andas 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 EffectSnob Effect


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The most direct way to obtain informationabout demand is through interviewswhere consumers are asked how much

of a product they would be willing to buyat a given price


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Problem

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


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In direct marketing experiments, actualsales offers are posed to potentialcustomers and the responses of

customers are observed


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The Statistical Approach to DemandEstimation

Properly applied, the statistical approach to

demand estimation can enable one to sortout the effects of variables on the quantitydemanded of a product

Least-squares regression is one approach


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Demand Data for Raspberries


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Assuming only price determines demand:

Q = a - bP

Q = 28.2 -1.00P


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Estimating Demand

Quantity

Price

0 5 10 15 20 25

15

10

5

25

20

d1

d2

d3

D

Drepresents demandif only Pdeterminesdemand and then fromthe data: Q=28.2-1.00P

Estimating Demand Changes in


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Estimating Demand Changes inIncome

Quantity

Price

0 5 10 15 20 25

15

10

5

25

20

D

d1

d2

d3

d1,d2,d3represent the demand foreach income level. Including incomein the demand equation: Q = a - bP +cIor Q =8.08 - .49P+ .81I


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Estimating Elasticities

For the demand equation: Q = a - bP

Elasticity:

)/()/)(/( QPbQPPQEP


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Assuming: Price and income elasticityare constant

The isoelastic demand =

)log()log()log( IcPbaQ

The slope, -b = price elasticity of demand

Constant, c = income elasticity of demand


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Using the Raspberry data:

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

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


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Substitutes: b2 is positive

Complements: b2 is negative

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

Complements and Substitutes

The Demand for Ready-to-Eat


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The Demand for Ready to EatCereal

Are Grape Nuts and Spoon SizeShredded 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

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