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
Effect of a Price Change
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
Effect of a Price Change
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
The Individual
Individual Demand
Demand Curve
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
The Individual
Individual Demand
Demand Curve
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
Effect of a Price Change
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
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
Effects of Income Changes
Clothing
Assume: Pf = $1
(units per
month) Pc = $2
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
Effects of Income Changes
Price An increase in income,
of from $10 to $20 to $30,
food with the prices fixed,
shifts the consumers
demand curve to the right.

E G H
$1.00

D3
D2
D1

Food (units
4 10 16 per month)

Chapter 4 Slide
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
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
 Individual Demand
Normal
Normal Good
Good vs.
vs. Inferior
Inferior Good
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
 Individual Demand
Normal
Normal Good
Good vs.
vs. Inferior
Inferior Good
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
An Inferior Good
Steak15
(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
Individual Demand

Engel Curves
Engelcurves relate the quantity of good
consumed to income.
Ifthe good is a normal good, the Engel
curve is upward sloping.
Ifthe good is an inferior good, the Engel
curve is downward sloping.

Chapter 4 Slide
Engel Curves
Income
($ per
month) 30

Engel curves slope

upward for
20 normal goods.

10

Food (units
0 4 8 12 16 per month)

Chapter 4 Slide
Engel Curves
Income
($ per
month) 30

Inferior
Engel curves slope
backward bending
20 for inferior goods.

Normal

10

Food (units
0 4 8 12 16 per month)

Chapter 4 Slide
 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
Substitutes and
and Complements
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
Individual Demand
Substitutes
Substitutes and
and Complements
Complements

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
Individual Demand
Substitutes
Substitutes and
and Complements
Complements

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
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
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
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
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
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
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
Income and Substitution
Effects:
Clothing
Normal Good
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 B prices constant but
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
Income and Substitution
Effects:
Clothing Inferior Good
(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
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.

Chapter 4 Slide
Effect of a Gasoline Tax With a Rebate

Assume
Ped = -0.5
Income = $9,000
Price of gasoline = $1

Chapter 4 Slide
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
 Market Demand
From
From Individual
Individual to
to Market
Market Demand
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
Determining the
Market Demand Curve
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)

1 6 1016 32

2 4 813 25

3 2 610 18

4 0 47 11

5 0 24 6

Chapter 4 Slide
Summing to Obtain a
Market Demand Curve
Price
5 The market demand
curve is obtained by
summing the consumers
4 demand curves

3
Market Demand
2

1
DA DB DC

0 5 10 15 20 25 30 Quantity

Chapter 4 Slide
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
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
 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
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
Market Demand

Point Elasticity of Demand

Point elasticity measures elasticity at a
point on the demand curve.
Its formula is:

EP (P/Q)(1/slope)
Chapter 4 Slide
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
Market Demand
Point
Point Elasticity
Elasticity of
of Demand
Demand (An
(An Example)
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
Market Demand
Point
Point Elasticity
Elasticity of
of Demand
Demand (An
(An Example)
Example)
Elasticity equals:
-33.33/.25 = -1.33 or -.50/.20 = -2.54
Which one is correct?

Chapter 4 Slide
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
Market Demand

Arc Elasticity of Demand (An Example)

EP ( Q/P)( P / Q)
P 8, P 10, Q 6, Q 4
1 2 1 2

P 18 / 2 9 & Q 10 / 2 5
E (2 / $2)($9 / 5) 1.8
p

Chapter 4 Slide
An Example:

The Aggregate Demand For Wheat

The demand for U.S. wheat is
comprised of domestic demand and
export demand.

Chapter 4 Slide
The Aggregate Demand For Wheat

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
The Aggregate Demand For Wheat

Domestic demand is relatively price

inelastic (-0.2), while export demand
is more price elastic (-0.4).

Chapter 4 Slide
The Aggregate Demand For Wheat

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
4 Export
Demand Domestic
Demand
2 F Wheat(million bushels/yr.)
D B
0 1000 2000 3000 4000

Chapter 4 Slide
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
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 =
14 21 Market Price

13

0 1 2 3 4 5 6 Rock Concert Tickets

Chapter 4 Slide
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
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
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
An 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 up the air worth the costs?

Chapter 4 Slide
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
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
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
Network Externalities

If this is the case, a network

externality exists.
Network externalities can be positive
or negative.

Chapter 4 Slide
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
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
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
Positive Network
Externality: Bandwagon Effect
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
Positive Network
Externality: Bandwagon Effect
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
Positive Network
Externality: Bandwagon Effect
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
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
Negative Network
Externality: Snob Effect
Price
($ per Originally demand is D2,
unit) Demand
when consumers think 2000
$30,000 people have bought a good.

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

Chapter 4 Slide
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)

Chapter
Pure 4
Price Effect Slide
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
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
Empirical Estimation of Demand

Problem
Consumers may lack information or
interest, or be mislead by the
interviewer.

Chapter 4 Slide
Empirical Estimation of Demand

In direct marketing experiments,

actual sales offers are posed to
potential customers and the
responses of customers are
observed.

Chapter 4 Slide
Empirical Estimation of Demand

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
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
Empirical Estimation of Demand

Assuming only price determines

demand:
Q = a - bP
Q = 28.2 -1.00P

Chapter 4 Slide
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
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
 Empirical Estimation of Demand
Estimating
Estimating Elasticities
Elasticities
For the demand equation: Q = a - bP
Elasticity: E P (Q / P )( P / Q ) b( P / Q)

Chapter 4 Slide
 Empirical Estimation of Demand
Estimating
Estimating Elasticities
Elasticities
Assuming: Price & income elasticity
are constant
The isoelastic demand =

log(Q) a b log( P ) c log( I )

Theslope, -b = price elasticity of demand
Constant, c = income elasticity

Chapter 4 Slide
 Empirical Estimation of Demand
Estimating
Estimating Elasticities
Elasticities
Using the Raspberry data:
log(Q) 0.81 2.4 log( P ) 1.46 log( I )
Price elasticity = -0.24 (Inelastic)
Income elasticity = 1.46

Chapter 4 Slide
 Empirical Estimation of Demand
Estimating
Estimating Complements
Complements and
and Substitutes
Substitutes

log(Q) a b log( P ) b2 log P2 c log( I )

Substitutes: b2 is positive
Complements: b2 is negative

Chapter 4 Slide
The Demand for Ready-to-Eat Cereal

What Do You Think?

AreGrape Nuts & Spoon Size
Shredded Wheat good substitutes?

Chapter 4 Slide
 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 = -2.0
Income elasticity = 0.62
Cross elasticity = 0.14

Chapter 4 Slide
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
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
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
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
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.

Chapter 4 Slide
End of Chapter 4
Individual and
Market Demand