Transcript Individual and Market Demand Chapter 4

Individual and
Market Demand
Chapter 4
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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
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Clothing
Assume:
•I = $20
•PC = $2
•PF = $2, $1, $0.50
10
A
6
U1
5
Each price leads to
different amounts of
food purchased
D
B
4
U3
U2
4
12
20
Food (units
per month)
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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.
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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
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5
Effect of a Price Change
Price
of Food
Individual Demand relates
the quantity of a good that
a consumer will buy to the
price of that good.
E
$2.00
G
$1.00
Demand Curve
$.50
H
4
12
20
Food (units
per month)
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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
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Effect of a Price Change
Price
of Food
When the price falls:
Pf/Pc & MRS also fall
E
$2.00
•E: Pf/Pc = 2/2 = 1 = MRS
•G: Pf/Pc = 1/2 = .5 = MRS
•H:Pf/Pc = .5/2 = .25 = MRS
G
$1.00
$.50
H
4
12
20
Demand Curve
Food (units
per month)
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Effects of Income Changes
Clothing
(units per
month)
Assume: Pf = $1, Pc = $2
I = $10, $20, $30
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D
5
U3
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
U2
B
3
U1
A
4
10
16
Food (units
per month)
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Income Changes
– When the income-consumption curve has a positive
slope:
• The quantity demanded increases with income.
• The income elasticity of demand is positive.
• The good is a normal good.
– When the income-consumption curve has a negative
slope:
• The quantity demanded decreases with income.
• The income elasticity of demand is negative.
• The good is an inferior good
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Engel Curves
–
Engel curves relate the quantity of good
consumed to income.
–
If the good is a normal good, the Engel curve is
upward sloping.
–
If the good is an inferior good, the Engel curve is
downward sloping.
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Engel Curves
Income 30
($ per
month)
Engel curves slope
upward for
normal goods.
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10
4
8
12
16
Food (units
per month)
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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 other
Ex: chicken and airplane tickets
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Substitutes & Complements
• A change in the price of a good has two
effects:
– Substitution Effect
– Income Effect
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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.
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• 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.
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Income and Substitution Effects: Normal Good
When the price of food falls,
consumption increases by F1F2
as the consumer moves from A
to B.
Clothing
(units per
month) R
C1
The substitution effect,F1E,
(from point A to D), changes the
relative prices but keeps real income
(satisfaction) constant.
A
C2
The income effect, EF2,
( from D to B) keeps relative
prices constant but
increases purchasing power.
B
D
U2
Substitution
Effect
F1
Total Effect
U1
E S
F2
T
Income Effect
Food (units
per month)
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Income and Substitution Effects: Inferior Good
Clothing
(units per
month) R
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.
B
U2
Substitution
Effect
F1
U1
E S
Total Effect
Income Effect
F2
Food (units
per month)
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Market Demand
• Price Elasticity of Demand
– Measures the percentage change in the
quantity demanded resulting from a percent
change in price.
%Q Q/Q Q P
EP 


%P P/P P Q
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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
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Market Demand
Elastic Demand
Ep is greater than than 1 in absolute value
Quantity demanded is relative responsive
to a change in price
%Q > %P
Total expenditure (P*Q) decreases when
price increases
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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)
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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. We
then add the right side of the equations, obtaining
QDD + QDE = (1430 − 55P) + (1470 − 70P) = 2900 − 125P
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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
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Consumer Surplus
Price
($ per
ticket)
Consumer Surplus
for the Market Demand
20
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CS = ½ ($20 - $14)*(1600)
= $19,500
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Market Price
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Demand Curve
Actual
Expenditure
0
1
2
3
4
5
6
Rock Concert Tickets
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Empirical Estimation of Demand
• Estimating Elasticities
– For the demand equation: Q = a - bP
• Elasticity:
EP  (Q / P)(P / Q)  b( P / Q)
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 of demand
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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
log(Q)  a  b log( P)  b2 log P2  c log( I )
• Substitutes: b2 is positive
• Complements: b2 is negative
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log(QGN )  1.998 2.085log(PGN )  0.62log(I )  0.14log(PSW )
Price elasticity = -2.0
Income elasticity = 0.62
Cross elasticity = 0.14
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