Individual and Market Demand

Chapter 4
Individual and
Market Demand
Topics to be Discussed
 Individual Demand
 Income and Substitution Effects
 Market Demand
 Consumer Surplus
Chapter 4 Slide 2
Topics to be Discussed
 Network Externalities
 Empirical Estimation of Demand
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
Clothing
(units per
month) Assume:
•I = $20
10 •PC = $2
•PF = $2, $1, $.50
6 A
U1 D
5 Three separate
B
indifference curves
4 U3
are tangent to
each budget line.
U2
Food (units
per month)
4 12 20
Chapter 4 Slide 5
Clothing The price-consumption
(units per curve traces out the
month) utility maximizing
market basket for the
various prices for food.
6 A
Price-Consumption Curve
U1 D
5
B
4 U3
U2
Food (units
4 12 20 per month)
Chapter 4 Slide 6
Price
of Food
Individual Demand relates
E the quantity of a good that
$2.00
a consumer will buy to the
price of that good.
G
$1.00
Demand Curve
$.50 H
Food (units
4 12 20 per month)
Chapter 4 Slide 7
Individual Demand
The Individual Demand Curve
 Two Important Properties of Demand

Curves
1) The level of utility that can be

attained changes as we move
along the curve.
Chapter 4 Slide 8
Individual Demand
The Individual Demand Curve
 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.
Chapter 4 Slide 9
Price When the price falls: Pf/Pc & MRS also fall
of Food
E
$2.00
•E: Pf/Pc = 2/2 = 1 = MRS

•G: Pf/Pc = 1/2 = .5 = MRS
G •H:Pf/Pc = .5/2 = .25 = MRS
$1.00
Demand Curve
$.50 H
Food (units
4 12 20 per month)
Chapter 4 Slide 10
Individual Demand
 Income Changes
 Using the Food-Clothing example
developed in chapter 3, the impact of a
change in income can be illustrated
using indifference curves.
Chapter 4 Slide 11
Effects of Income Changes
Clothing
Assume: Pf = $1
(units per
Pc = $2
month)
I = $10, $20, $30
Income-Consumption
Curve
7 D
U3 An increase in income,
with the prices fixed,
5 U2 causes consumers to alter
B their choice of
3 market basket.
A U1
Food (units
4 10 16 per month)
Chapter 4 Slide 12
Effects of Income Changes
Price An increase in income,
of from $10 to $20 to $30,
food with the prices fixed,
shifts the consumer’s
demand curve to the right.
E G H
$1.00
D3
D2
D1
Food (units
4 10 16 per month)
Chapter 4 Slide 13
Individual Demand
 Income Changes
 The income-consumption curve traces
out the utility-maximizing combinations
of food and clothing associated with
every income level.
Chapter 4 Slide 14
Individual Demand
 Income Changes
 An increase in income shifts the budget
line to the right, increasing consumption
along the income-consumption curve.
 Simultaneously, the increase in income
shifts the demand curve to the right.
Chapter 4 Slide 15
Individual Demand
Normal Good vs. Inferior Good
 Income Changes
 When the income-consumption curve
has a positive slope:
 The quantity demanded increases
with income.
 The income elasticity of demand is
positive.
 The good is a normal good.
Chapter 4 Slide 16
Individual Demand
Normal Good vs. Inferior Good
 Income Changes
 When the income-consumption curve
has a negative slope:
 The quantity demanded decreases
with income.
 The income elasticity of demand is
negative.
 The good is an inferior good.
Chapter 4 Slide 17
An Inferior Good
Steak 15
(units per Income-Consumption
month) Curve
Both hamburger
and steak behave
C as a normal good,
10 between A and B...
U3
…but hamburger
becomes an inferior
B good when the income
5 consumption curve
bends backward
U2 between B and C.
A
U1
Hamburger
5 10 20 30 (units per month)
Chapter 4 Slide 18
Individual Demand
 Engel Curves
 Engel curves relate the quantity of good
consumed to income.
 If the good is a normal good, the Engel
curve is upward sloping.
 If the good is an inferior good, the Engel
curve is downward sloping.
Chapter 4 Slide 19
Engel Curves
Income
($ per
month) 30
Engel curve slopes

upward for a
20 normal good.
10
Food (units
0 4 8 12 16 per month)
Chapter 4 Slide 20
Engel Curves
Income
($ per
month) 30
Inferior
Engel curve is
backward bending
20 for inferior goods.
Normal
10
Food (units
0 4 8 12 16 per month)
Chapter 4 Slide 21
Consumer Expenditures
in the United States
Income Group (1997 $)
Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000-

($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above
Entertainment 700 947 1274 1514 2054 2654 4300
Owned Dwellings 1116 1725 2253 3243 4454 5793 9898
Rented Dwellings1957 2170 2371 2536 2137 1540 1266
Health Care 1031 1697 1918 1820 2052 2214 2642
Food 2656 3385 4109 4888 5429 6220 8279
Clothing 859 978 1363 1772 1778 2614 3442

Individual Demand
Substitutes and Complements
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
Chapter 4 Slide 23
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
Chapter 4 Slide 24
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.
Chapter 4 Slide 25
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.
 They could be both!
Chapter 4 Slide 26
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 27
 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 28
 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 of the item
demanded.
Chapter 4 Slide 29
 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.
Chapter 4 Slide 30
 Income Effect
 Even with inferior goods, the income
effect is rarely large enough to outweigh
the substitution effect.
Chapter 4 Slide 31
Income and Substitution
Effects: Normal Good
Clothing
When the price of food falls,
(units per consumption increases by F1F2
month) R as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
C1 A relative prices but keeps real income
(satisfaction) constant.
The income effect, EF2,

( from D to B) keeps relative
D prices constant but
B
C2 increases purchasing power.
Substitution U2
Effect U1
Food (units
O F1 Total Effect E S F2 T per month)
Income Effect
Chapter 4 Slide 32
Income and Substitution
Effects: Inferior Good
Clothing
(units per Since food is an
month) R inferior good, the
income effect is
negative. However,
the substitution effect
A is larger than the
income effect.
B
U2
D
Substitution
Effect U1
Food (units
O F1 E S F2 T per month)
Total Effect
Income Effect
Chapter 4 Slide 33
 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.
Chapter 4 Slide 34
Effect of a Gasoline Tax With a Rebate
 Assume
 Ped = -0.5
 Income = $9,000
 Price of gasoline = $1
Chapter 4 Slide 35
Effect of a Gasoline Tax With a Rebate
Expenditures
On Other
Goods ($) After Gasoline Tax
F Plus Rebate
A •$.50 Excise Tax
•Gasoline = 900 gallons
•$450 REBATE
•New budget line
•Consumer is worse off
H C
After •Gasoline = 1200 gallons
Gasoline E •Other expenditures = $7800
Tax U2
U3
U1 Original Budget
Line
Gasoline Consumption
900 913.5 1200 D J B (gallons/year)
Chapter 4 Slide 36
Market Demand
From Individual to 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.
Chapter 4 Slide 37
Determining the
Market Demand Curve
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)
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
Chapter 4 Slide 38
Summing to Obtain a
Market Demand Curve
Price
5 The market demand
curve is obtained by
summing the consumer’s
4 demand curves
3
Market Demand
2
1
DA DB DC
0 5 10 15 20 25 30 Quantity
Chapter 4 Slide 39
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 40
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.
Q/Q Q / P
EP  
P/P Q/P
Chapter 4 Slide 41
Price Elasticity and
Consumer Expenditure
Demand If Price Increases, If Price Decreases,

Expenditures: Expenditures:
Inelastic (Ep <1) Increase Decrease
Unit Elastic (Ep = 1) Are unchanged Are unchanged
Elastic (Ep >1) Decrease Increase
Chapter 4 Slide 42
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 43
Market Demand
 Point Elasticity of Demand

 Point elasticity measures elasticity at a
point on the demand curve.
 Its formula is:
EP  (P/Q)(1/sl ope)
Chapter 4 Slide 44
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 45
Market Demand
Point Elasticity of Demand (An Example)
 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%
Chapter 4 Slide 46
Market Demand
Point Elasticity of Demand (An Example)
 Elasticity equals:
-33.33/25 = -1.33 or -50/20 = -2.5
 Which one is correct?
Chapter 4 Slide 47
Market Demand
 Arc Elasticity of Demand

 Arc elasticity calculates elasticity over a
range of prices
 Its formula is:
EP  ( Q/P)( P / Q)
P  the average price
Q  the average quantity
Chapter 4 Slide 48
Market Demand
 Arc Elasticity of Demand (An Example)

EP  ( Q/P)( P / Q)
10  8
P1  8 P 2  10 P 9
2
64
Q1  6 Q2  4 Q 5
2
Ep  (2 / $2)($9 / 5)  1.8
Chapter 4 Slide 49
An Example:
The Aggregate Demand For Wheat

 The demand for U.S. wheat is
comprised of domestic demand and
export demand.
Chapter 4 Slide 50
 The domestic demand for wheat is

given by the equation:
 QDD = 1700 - 107P
 The export demand for wheat is

given by the equation:
 QDE = 1544 - 176P
Chapter 4 Slide 51
 Domestic demand is relatively price

inelastic (-0.2), while export demand
is more price elastic (-0.4).
Chapter 4 Slide 52
Price
($/bushel) 20
18
Total world demand is
16 A the horizontal sum of the
domestic demand AB and
14 export demand CD.
12
10
C E
8
6 Total Demand
Export
4 Demand Domestic
Demand
2 F Wheat(million bushels/yr.)
D B
0 1000 2000 3000 4000
Chapter 4 Slide 53
Consumer Surplus
 Consumer Surplus
 The difference between the maximum
amount a consumer is willing to pay for
a good and the amount actually paid.
Chapter 4 Slide 54
Consumer Surplus
Price The consumer surplus
($ per 20 of purchasing 6 concert
ticket) tickets is the sum of the
19 surplus derived from
18 each one individually.
17
16
Consumer Surplus
15
6 + 5 + 4 + 3 + 2 + 1 = 21
14 Market Price
13
0 1 2 3 4 5 6 Rock Concert Tickets

Chapter 4 Slide 55
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 56
Consumer Surplus
Price Consumer Surplus
($ per 20
ticket) for the Market Demand
19
18
17
16 Consumer
Surplus
15
1/2x(20  14)x6,500  $19,500
14 Market Price
13
Demand Curve
Actual
Expenditure
0 1 2 3 4 5 6 Rock Concert Tickets

Chapter 4 Slide 57
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 58
An Example:
The Value of Clean Air

 Air is free in the sense that we don’t
pay to breathe it.
 The Clean Air Act was amended in

1970.
 Question: Were the benefits of

cleaning up the air worth the costs?
Chapter 4 Slide 59
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 60
Valuing Cleaner Air
Value
($ per pphm
of reduction)
The shaded area gives the
2000 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.
A
1000
NOX (pphm)
0 5 10 Pollution Reduction
Chapter 4 Slide 61
Network Externalities
 Up to this point we have assumed

that people’s demands for a good are
independent of one another.
 If fact, a person’s demand may be

affected by the number of other
people who have purchased the
good.
Chapter 4 Slide 62
 If this is the case, a network

externality exists.
 Network externalities can be positive

or negative.
Chapter 4 Slide 63
 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 64
 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 65
Positive Network
Externality: Bandwagon Effect
When consumers believe more
Price D20 D40 D60 D80 D100 people have purchased the
($ per
unit)
product, the demand curve shifts
further to the the right .
Quantity
20 40 60 80 100 (thousands per month)
Chapter 4 Slide 66
Positive Network
Price D20 D40 D60 D80 D100 The market demand

($ per curve is found by joining
unit)
the points on the individual
demand curves. It is relatively
more elastic.
Demand
Quantity
20 40 60 80 100 (thousands per month)
Chapter 4 Slide 67
Positive Network
Price D20 D40 D60 D80 D100 Suppose the price falls
($ per from $30 to $20. If there
unit)
were no bandwagon effect,
quantity demanded would
$30 only increase to 48,000
$20 Demand
Pure Price
Effect
Quantity
20 40 48 60 80 100 (thousands per month)
Chapter 4 Slide 68
Positive Network
Price D20 D40 D60 D80 D100 But as more people buy
($ per the good, it becomes
unit)
stylish to own it and
the quantity demanded
$30 increases further.
$20 Demand
Pure Price Bandwagon

Effect
Effect
Quantity
20 40 48 60 80 100 (thousands per month)
Chapter 4 Slide 69
 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 70
Negative Network
Externality: Snob Effect
Price
($ per Originally demand is D2,
unit) Demand when consumers think 2000
people have bought a good.
$30,000
However, if consumers think 4,000

people have bought the good,
demand shifts from D2 to D6 and its
snob value has been reduced.
$15,000
D2
D4
D6
D8
Quantity (thousands
2 4 6 8 14 per month)
Pure Price Effect

Negative Network
Externality: Snob Effect
Price
($ per The demand is less elastic and
unit) Demand as a snob good its value is greatly
reduced if more people own
$30,000 it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.
Net Effect Snob Effect
$15,000
D2
D4
D6
D8
Quantity (thousands
2 4 6 8 14 per month)
Pure Price Effect

Network Externalities and the Demands
for Computers and Fax Machines
 Examples of Positive Feedback

Externalities
 Mainframe computers: 1954 - 1965
 Microsoft Windows PC operating

system
 Fax-machines and e-mail
Chapter 4 Slide 73
Empirical Estimation of Demand
 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
price.
Chapter 4 Slide 74
 Problem
 Consumers may lack information or
interest, or be mislead by the
interviewer.
Chapter 4 Slide 75
 In direct marketing experiments,

actual sales offers are posed to
potential customers and the
responses of customers are
observed.
Chapter 4 Slide 76
 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.
Chapter 4 Slide 77
Demand Data for Raspberries
Year Quantity (Q) Price (P) Income(I)
1988 4 24 10
1989 7 20 10
1990 8 17 10
1991 13 17 17
1992 16 10 17
1993 15 15 17
1994 19 12 20
1995 20 9 20
1996 22 5 20
Chapter 4 Slide 78
 Assuming only price determines

demand:
Q = a - bP
Q = 28.2 -1.00P
Chapter 4 Slide 79
Estimating Demand
Price
25
D represents demand
if only P determines
20 demand and then from
the data: Q=28.2-1.00P
15
d1
10
5 d2 D
d3
0 5 10 15 20 25 Quantity
Chapter 4 Slide 80
Estimating Demand
Price Adjusting for changes in income
25
d1, d2, d3 represent the demand for each
income level. Including income in the
20 demand equation: Q = a - bP + cI or
Q = 8.08 - .49P + .81I
15
d1
10
5 d2 D
d3
0 5 10 15 20 25 Quantity
Chapter 4 Slide 81
Estimating Elasticities
 For the demand equation: Q = a - bP
 Elasticity: EP  (Q / P)( P / Q)  b( P / Q)
Chapter 4 Slide 82
 Assuming: Price & income elasticity

are constant
 The isoelastic demand =
log(Q)  a  b log( P)  c log( I )

 The slope, -b = price elasticity of demand
 Constant, c = income elasticity
Chapter 4 Slide 83
 Using the Raspberry data:

log( Q)  0.81  .24 log( P)  1.46 log( I )
 Price elasticity = -0.24 (Inelastic)
 Income elasticity = 1.46
Chapter 4 Slide 84
Estimating Complements and Substitutes
log(Q)  a  b log( P)  b2 log P2  c log( I )

 Substitutes: b2 is positive
 Complements: b2 is negative
Chapter 4 Slide 85
The Demand for Ready-to-Eat Cereal
 What Do You Think?

 Are Grape Nuts & Spoon Size
Shredded Wheat good substitutes?
Chapter 4 Slide 86
The Demand for Ready-to-Eat Cereal
 Answer
 Estimated demand for Grape Nuts (GN)
log( QGN )  1.998a  2.085 log( PGN )  0.62 log( I )  .014 log( PSW )
 Price elasticity = -2.085
 Income elasticity = 0.62
 Cross price elasticity = 0.14
Chapter 4 Slide 87
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 88
Summary
 Two goods are substitutes (complements)

if an increase (decrease) in the price of
one good leads to an increase in the
quantity demanded of the other.
 The effect of a price change on the

quantity demanded can be broken into a
substitution effect and an income effect.
Chapter 4 Slide 89
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 90
Summary
 There is a network externality when

one person’s demand is affected
directly by the purchasing decisions
of other consumers.
 A number of methods can be used to

obtain information about consumer
demand.
Chapter 4 Slide 91
End of Chapter 4
Individual and
Market Demand

Individual and Market Demand

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Chapter 4

 Income and Substitution Effects

 Empirical Estimation of Demand

 Two Important Properties of Demand

1) The level of utility that can be

 Two Important Properties of Demand

•E: Pf/Pc = 2/2 = 1 = MRS

Engel curve slopes

Income Group (1997 $)

Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000-

Entertainment 700 947 1274 1514 2054 2654 4300

Owned Dwellings 1116 1725 2253 3243 4454 5793 9898

Rented Dwellings1957 2170 2371 2536 2137 1540 1266

Health Care 1031 1697 1918 1820 2052 2214 2642

Food 2656 3385 4109 4888 5429 6220 8279

Clothing 859 978 1363 1772 1778 2614 3442

1) Two goods are considered

2) Two goods are considered

3) Two goods are independent when a

 Substitutes and Complements

 They could be both!

 A fall in the price of a good has two

 A fall in the price of a good has two

The income effect, EF2,

 A Special Case--The Giffen Good

 Market Demand Curves

 Two Important Points

1) The market demand will shift to

2) Factors that influence the

Demand If Price Increases, If Price Decreases,

Inelastic (Ep <1) Increase Decrease

Unit Elastic (Ep = 1) Are unchanged Are unchanged

Elastic (Ep >1) Decrease Increase

 Point Elasticity of Demand

 Point Elasticity of Demand

 Problems Using Point Elasticity

 Percent change in price equals:

 Arc Elasticity of Demand

 Arc Elasticity of Demand (An Example)

The Aggregate Demand For Wheat

 The domestic demand for wheat is

 The export demand for wheat is

 Domestic demand is relatively price

0 1 2 3 4 5 6 Rock Concert Tickets

 The stepladder demand curve can be

0 1 2 3 4 5 6 Rock Concert Tickets

 Combining consumer surplus with

1) Costs and benefits of different

2) Public policies that alter the

The Value of Clean Air

 The Clean Air Act was amended in

 Question: Were the benefits of

 People pay more to buy houses

 Data for house prices among

 Up to this point we have assumed

 If fact, a person’s demand may be

 If this is the case, a network

 Network externalities can be positive

 A positive network externality exists if

 Negative network externalities are

 The Bandwagon Effect

Price D20 D40 D60 D80 D100 The market demand

Pure Price Bandwagon