Chapter 4

Individual and
Market Demand
Chapter 4 Slide 2
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Chapter 4 Slide 3
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.
Chapter 4 Slide 4
Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U
2
U
3
A
B
D
U
1
4 12 20
Three separate
indifference curves
are tangent to
each budget line.
Assume:
I =$20
P
C
=$2
P
F
=$2, $1, $.50
10
Chapter 4 Slide 5
Price-Consumption Curve
Effect of a Price Change
Food (units
per month)
Clothing
(units per
month)
4
5
6
U
2
U
3
A
B
D
U
1
4 12 20
The price-consumption
curve traces out the
utility maximizing
market basket for the
various prices for food.
Chapter 4 Slide 6
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
Chapter 4 Slide 7
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 Curve
Chapter 4 Slide 8
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 Curve
Chapter 4 Slide 9
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: P
f
/P
c
=2/2 = 1 = MRS
G: P
f
/P
c
=1/2 =.5 = MRS
H:P
f
/P
c
=.5/2 = .25 = MRS
When the price falls: P
f
/P
c
& MRS also fall
Lecture 13 slide 10
Perfect complements
Burgers
fries
Price Consumption
Curve
Lecture 13 slide 11
Perfect substitutes
Pepsi
Coke
If the price of Cokes decreases
PRICE CONSUMPTION
CURVE ?
12
Giffen Good
Own Price Changes and
Deriving a Demand Curve
Giffen Good A good with a positively
sloped demand curve, because the consumer
purchases more of the good as the price
increases.
13
Giffen Good
Chapter 4 Slide 14
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.
Chapter 4 Slide 15
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
U
1
5
10
B
U
2
D 7
16
U
3
Assume: P
f
=$1
P
c
= $2
I =$10, $20, $30
Chapter 4 Slide 16
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 consumers
demand curve to the right.
$1.00
4
D
1
E
10
D
2
G
16
D
3
H
Chapter 4 Slide 17
Individual Demand
Income Changes
The income-consumption curve traces
out the utility-maximizing combinations
of food and clothing associated with
every income level.
Chapter 4 Slide 18
Individual Demand
Income Changes
An increase in income shifts the budget
line to the right, increasing consumption
along the income-consumption curve.
Simultaneously, the increase in income
shifts the demand curve to the right.
Chapter 4 Slide 19
Individual Demand
Income Changes
When the income-consumption curve
has a positive slope:
The quantity demanded increases
with income.
The income elasticity of demand is
positive.
The good is a normal good.
Normal Good vs. Inferior Good
Chapter 4 Slide 20
Individual Demand
Income Changes
When the income-consumption curve
has a negative slope:
The quantity demanded decreases
with income.
The income elasticity of demand is
negative.
The good is an inferior good.
Normal Good vs. Inferior Good
Chapter 4 Slide 21
An Inferior Good
Hamburger
(units per month)
Steak
(units per
month)
15
30
U
3
C
Income-Consumption
Curve
but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C.
10 5 20
5
10
A
U
1
B
U
2
Both hamburger
and steak behave
as a normal good,
between A and B...
Chapter 4 Slide 22
Individual Demand
Engel Curves
Engel curves relate the quantity of good
consumed to income.
If the good is a normal good, the Engel
curve is upward sloping.
If the good is an inferior good, the Engel
curve is downward sloping.
Chapter 4 Slide 23
Engel Curves
Food (units
per month)
30
4 8 12
10
Income
($ per
month)
20
16 0
Engel curves slope
upward for
normal goods.
Chapter 4 Slide 24
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
16 0
Chapter 4 Slide 25
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 Complements
Chapter 4 Slide 26
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 Complements
Chapter 4 Slide 27
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 Complements
Chapter 4 Slide 28
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.
Income and Substitution Effects
Consider how a consumer might
respond when the price of Pepsi has
fallen:
Great news! Now that Pepsi is
cheaper, my income has greater
purchasing power. I am, in effect,
richer than I was. Because Im richer,
I can buy both more pizza and more
Pepsi. (This is the income effect)
Chapter 4 Slide 29
Income and Substitution Effects
Now that the price of Pepsi has
fallen, I get more pints of Pepsi for
every pizza that I give up. Because
pizza is now relatively more
expensive, I should buy less pizza
and more Pepsi. (This is the
substitution effect.)
Chapter 4 Slide 30
Chapter 4 Slide 31
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.
Chapter 4 Slide 32
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.
Chapter 4 Slide 33
Income and Substitution Effects
Substitution Effect
The substitution effect is the change in
an items 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.
Chapter 4 Slide 34
Income and Substitution Effects
Income Effect
The income effect is the change in an
items consumption brought about by
the increase in purchasing power, with
the price of the item held constant.
When a persons income increases, the
quantity demanded for the product may
increase or decrease.
Chapter 4 Slide 35
Income and Substitution Effects
Income Effect
Even with inferior goods, the income
effect is rarely large enough to outweigh
the substitution effect.
Chapter 4 Slide 36
Income and Substitution
Effects: Normal Good
Food (units
per month) O
Clothing
(units per
month)
R
F
1
S
C
1 A
U
1
The income effect, EF
2
,
( from D to B) keeps relative
prices constant but
increases purchasing power.
Income Effect
C
2
F
2
T
U
2
B
When the price of food falls,
consumption increases by F
1
F
2

as the consumer moves from A
to B.
E
Total Effect
Substitution
Effect
D
The substitution effect,F
1
E,
(from point A to D), changes the
relative prices but keeps real income
(satisfaction) constant.
Chapter 4 Slide 37
Food (units
per month)
O
R
Clothing
(units per
month)
F
1
S F
2
T
A
U
1
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
U
2
Income and Substitution
Effects: Inferior Good
Lecture 13 slide 38
Perfect complements
Burgers
fries
Total effect = Income effect
Therefore, you could have
achieved the same total effect
by just increasing income,
instead of reducing
the price
F1 F2
A
B
U1
U2
Lecture 13 slide 39
Perfect substitutes
Pepsi
Coke
Total effect
= Substitution effect + income effect
If the price of Coke decreases
A
B U1
U2
Chapter 4 Slide 41
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.
INCOME AND SUBSTITUTION EFFECTS: GIFFEN GOOD
Giffen good
Good whose
demand curve
slopes upward
because the
(negative)
income effect is
larger than the
substitution
effect.
Chapter 4 Slide 43
Effect of a Gasoline Tax With a Rebate
Assume
P
e
d
= -0.5
Income = $9,000
Price of gasoline = $1
Chapter 4 Slide 44
Effect of a Gasoline Tax With a Rebate
Gasoline Consumption
(gallons/year)
Expenditures
On Other
Goods ($)
A
C
Gasoline = 1200 gallons
Other expenditures = $7800
U
2
1200
Original Budget
Line
B D
U
1
900
After
Gasoline
Tax
E
$.50 Excise Tax
Gasoline = 900 gallons
J
F
H
913.5
After Gasoline Tax
Plus Rebate
U
3
$450 REBATE
New budget line
Consumer is worse off
Chapter 4 Slide 45
Market Demand
Market Demand Curves
A curve that relates the quantity of a
good that all consumers in a market buy
to the price of that good.
From Individual to Market Demand
Chapter 4 Slide 46
Determining the
Market Demand Curve
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)
Chapter 4 Slide 47
Summing to Obtain a
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
D
B
D
C
Market Demand
D
A
The market demand
curve is obtained by
summing the consumers
demand curves
Chapter 4 Slide 48
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.
Chapter 4 Slide 49
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.
P Q
P Q
P/P
Q/Q
EP
/
/

Computing the Price Elasticity

of Demand
The price elasticity of demand is
computed as the percentage change in
the quantity demanded divided by the
percentage change in price.

Price Elasticity = Percentage Change in Qd
Of Demand Percentage Change in Price
Chapter 4 Slide 51
Price Elasticity and
Consumer Expenditure
Demand If Price Increases, If Price Decreases,
Expenditures: Expenditures:
Inelastic (E
p
<1) Increase Decrease
Unit Elastic (E
p
=1) Are unchanged Are unchanged
Elastic (E
p
>1) Decrease Increase
Chapter 4 Slide 52
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.
Chapter 4 Slide 54
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.
Chapter 4 Slide 55
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)
Chapter 4 Slide 56
Market Demand
Elasticity equals:
-33.33/.25 = -1.33 or -.50/.20 = -2.54
Which one is correct?
Point Elasticity of Demand (An Example)
Chapter 4 Slide 57
Market Demand
Arc Elasticity of Demand
Arc elasticity calculates elasticity over a
range of prices
Its formula is:
e quantity the averag Q
e price the averag P
Q P P)( Q/ ( E P

) /
Chapter 4 Slide 58
Market Demand
Arc Elasticity of Demand (An Example)



8 . 1 ) 5 / 9 )($ 2 $ / 2 (
5 2 / 10 & 9 2 / 18
4 , 6 , 10 , 8
) /
2 1 2 1




p E
Q P
Q Q P P
Q P P)( Q/ ( E P
Demand Curves
Question: Can I tell from the
graphical shape of the demand curve
what kind of elasticity the curve has?
Answer: Yes, but not all the time.
Perfectly Inelastic Demand
Elasticity = 0
$5
4
Quantity
Demand
100 0
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price
3. . . . revenue goes from $4 x 100 to $5 x 100
Inelastic Demand
Elasticity < 1
Quantity 0
$5
90
Demand
1. A 22%
increase
in price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100
3. . . . revenue goes from $4 x 100 to $5 x 90
Unit Elastic Demand
Elasticity = 1
Quantity 0
$5
80
1. A 22%
increase
in price . . .
Price
2. . . . leads to a 22% decrease in quantity demanded.
4
100
Demand
3. . . . revenue goes from $4 x 100 to $5 x 80
Elastic Demand
Elasticity > 1
Quantity 0
$5
50
1. A 22%
increase
in price . . .
Price
2. . . . leads to a 67% decrease in quantity demanded.
4
100
Demand
3. . . . revenue goes from $4 x 100 to $5 x 50
Perfectly Elastic Demand
Elasticity = Infinity
Quantity 0
Price
$4 Demand
2. At exactly $4,
consumers will
buy any quantity.
1. At any price
above $4, quantity
demanded is zero.
3. At a price below $4,
quantity demanded is infinite.
Elasticity & Its Application
Evaluating questions like-
Banana Republic store manager/headquarters
needs to decide on sale on jeans vs. sale on
shirts
Rain destroys strawberry crop, prices go .
Does it benefit growers ?
Why dont you ever see sale or discounts on
pure milk but see it on orange juice ?
These can be answered with the concept
of elasticity (or responsiveness of buyers
& sellers to changes in market conditions)

Income Elasticity of Demand
Income elasticity of demand measures
the percentage change in quantity
demanded due to a percentage change
in income


e quantity the averag Q
e income the averag I
Q I I)( Q/ ( E I

) /
Income Elasticity of Demand:
Normal Good demand rises as
income rises and vice versa

Inferior Good demand falls as
income rises and vice versa

Look out for the sign!
A positive sign (+) denotes a normal
good

A negative sign (-) denotes an
inferior good
- Negative Income Elasticity
An increase in income will result in a
decrease in demand.
A decrease in income will result in a
rise in demand.
ALSO known as INFERIOR GOODS
Negative Income Elasticity Diagram
= Inferior
Note the different axes labels
Zero Income Elasticity
This occurs when a
change in income
has NO effect on the
demand for goods.
A rise of 5% income
in a rich country will
leave the Demand
for toothpaste
unchanged!
Chapter 4 Slide 74
Income Elasticity
Income Elasticity of Demand (An
Example)



8 . 1 ) 5 / 900 )($ 200 $ / 2 (
5 2 / 10 & 900 2 / 1800
4 , 6 , 1000 , 800
) /
2 1 2 1




I E
Q I
Q Q I I
Q I I)( Q/ ( E I
Other Elasticities of Demand
Cross Price Elasticity of Demand
The percentage change in the quantity
demanded of one good in response to a
one-percent change in the price of
another good
Positive for substitutes
Negative for complements
Chapter 4 Slide 76
Consumer Surplus
Consumer Surplus
The difference between the maximum
amount a consumer is willing to pay for
a good and the amount actually paid.
Chapter 4 Slide 77
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
Chapter 4 Slide 78
Consumer Surplus
The stepladder demand curve can be
converted into a straight-line demand
curve by making the units of the good
smaller.
Chapter 4 Slide 79
Demand Curve
Consumer
Surplus
Actual
Expenditure
$19,500 14)x6,500 1/2x(20
Consumer Surplus
for the Market Demand
Consumer Surplus
Rock Concert Tickets
Price
($ per
ticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Chapter 4 Slide 80
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
Chapter 4 Slide 81
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 up the air worth the costs?
An Example:
Chapter 4 Slide 82
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.
Chapter 4 Slide 83
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 $1000 per
part reduced.
Valuing Cleaner Air
2000
10 0
1000
5
A
NOX (pphm)
Pollution Reduction
Value
($ per pphm
of reduction)
Chapter 4 Slide 84
Network Externalities
Up to this point we have assumed
that peoples demands for a good are
independent of one another.
If fact, a persons demand may be
affected by the number of other
people who have purchased the
good.
Chapter 4 Slide 85
Network Externalities
If this is the case, a network
externality exists.
Network externalities can be positive
or negative.
Chapter 4 Slide 86
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.
Chapter 4 Slide 87
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).
Chapter 4 Slide 88
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20 40
When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right .
D
40
60
D
60
80
D
80
100
D
100
Chapter 4 Slide 89
Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20 40 60 80 100
D
40
D
60
D
80
D
100
The market demand
curve is found by joining
the points on the individual
demand curves. It is relatively
more elastic.
Chapter 4 Slide 90
Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20 40 60 80 100
D
40
D
60
D
80
D
100
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
$30
Chapter 4 Slide 91
Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20 40 60 80 100
D
40
D
60
D
80
D
100
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.
$30
Chapter 4 Slide 92
Network Externalities
The Snob Effect
If the network externality is negative, a
snob effect exists.
The snob effect refers to the desire to
own exclusive or unique goods.
The quantity demanded of a snob
good is higher the fewer the people
who own it.
Chapter 4 Slide 93
Negative Network
Externality: Snob Effect
Quantity (thousands
per month)
Price
($ per
unit)
Demand
2
D
2
$30,000
$15,000
14
Pure Price Effect
Originally demand is D
2
,
when consumers think 2000
people have bought a good.
4 6 8
D
4
D
6
D
8
However, if consumers think 4,000
people have bought the good,
demand shifts from D
2
to D
6
and

its
snob value has been reduced.
Chapter 4 Slide 94
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)
D
2
$30,000
$15,000
14
D
4
D
6
D
8
Demand
Pure Price Effect
Snob Effect
Net Effect
Chapter 4 Slide 95
Network Externalities and the Demands
for Computers and Fax Machines
Examples of Positive Feedback
Externalities
Microsoft Windows PC operating
system
Social Networking Sites

Chapter 4 Slide 96
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.
Chapter 4 Slide 97
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.
Chapter 4 Slide 98
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.
Chapter 4 Slide 99
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.
Chapter 4 Slide 100
Summary
There is a network externality when
one persons demand is affected
directly by the purchasing decisions
of other consumers.
A number of methods can be used to
obtain information about consumer
demand.