Transcript Chapter 4

Chapter 4
INDIVIDUAL AND
MARKET DEMAND
*Focus is on how purchase decisions respond to variations in price and
income.
*Recall the Budget Constraint: PS *S + PF * F = M: slope = - PF/PS
*The IC analysis in Chapter 3 is employed in analyzing consumer respond to
price and income changes.
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Chapter Outline
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The Effects of Changes in the Price
The Effects of Changes in Income
The Income and Substitution Effects of a Price Change
Consumer Responsiveness to Changes in Price
Market Demand: Aggregating Individual Demand Curves
Price Elasticity of Demand
The Dependence of Market Demand on Income
Application: Forecasting Economic Trends
Cross-price Elasticities of Demand
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Figure 4.1: The Price-Consumption Curve
Goods = X and Y
An Individual
Consumer’s Demand
Curve
The Effect of Changes in Price
Price-consumption curve (PCC): for a good X is the set of optimal bundles
traced on an indifference map as the price of X varies (holding income and
the price of Y constant). Note: as one moves along a demand curve, the real
standard of living changes
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Figure 4.3: An Income-Consumption
Curve
Normal good: one whose
quantity demanded rises
as income rises.
Inferior good: one whose
quantity demanded falls
as income rises.
The Effects of Changes in Income
Income-consumption curve (ICC): for a good X is the set of optimal bundles
traced on an indifference map as income varies (holding the prices of X and Y
constant).
Engel curve: curve that plots the relationship between the quantity of X
consumed and income.
Note: As income increases, the consumption of Shelter increases, ceteris
paribus. Hence, Shelter is a normal good.
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Engel Curves – relates income to the consumption of a good.
Figure 4.4: An Individual
Consumer’s Engel Curve
Figure 4.5: The Engel Curve
for Normal and Inferior Goods
Engel Curve – curve that plots the relationship between the quantity of X
(=shelter in this case) consumed and income, ceteris paribus on (a)
tastes/preferences and relative prices.
Note: similar to the ICC curve. Differences lie on the verticals: the ICC –
measures consumer expenditure but Engel Curve –consumer’s income
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Figure 4.6: The Total Effect of a Price Increase
Income and Substitution Effects
Substitution effect: that
component of the total effect of a
price change that results from the
associated change in the relative
attractiveness of other goods.
Income effect: that component
of the total effect of a price
change that results from the
associated change in real
purchasing power.
The Slutsky Equation =
Overall Q X Q X
Q X

|U Q X
Given PX
PX
 Income
Total effect: the sum of the
substitution and income effects.
The Income Effect can be easily weighted against the negative Substitution Effect to see
if a Giffen or Inferior good is present. The 1st RHS term is the Substitution Effect (always
negative) but the 2nd term is the Income Effect which can be positive (for a normal
good) or negative (for an inferior good).
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Figure 4.7: The Substitution and Income
Effects of a Price Sensitive Good
A->C: Substitution Effect -> 6-10 =-4
C->D: Income Effect ->-2-6=-4
Total Effect = -4+-4 = -8
Figure 4.8: Income and Substitution
Effects for an Inferior Good
A->C: 8-12=-4= reduction of
Substitution Effect (negative)
C->D: 9-8= +1-> Income
Effect (positive)
Overall Effect/Total Effect =
-4+1 = -3:Price increases ≈
income decrease
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Figure 4.13: Income and Substitution Effects for a
Price-Sensitive Good
Substitution Effect: 55-100 =-45
Income Effect : 20-55 = -35
Total Effect = -35+ -45 = -80
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Figure 4.16: Generating Market Demand
from Individual Demands
Market Demand Curves
Market demand curve: the horizontal summation of the individual demand
curves. Note: it requires that demands be stated as Q =f(p) not P=f(Q). The
latter is standard and we have Alfred Marshall to blame. Horizontal addition
makes sense with the former but it is difficult to change convention!
Price elasticity of demand: the present percentage change in the quantity of
a good demanded that result from a 1 present change in its price, ceteris
paribus
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Three Categories of Price Elasticity
1.Elastic → € < -1
2. Inelastic → € > -1
3. Unit elastic → € = 1
Elasticity is important see most consumers tend to see the world in terms of
proportions rather than absolute values. Check yourself against the
following behavior.
1.
Why will you drive across town to get a shirt for $10 off the regular
price but choose to stay with your regular car dealer if the car costs
$10 more?
2. Why would there be rejoicing in the hall if the price of Coke fell 25
cents in the dorm machine, but scoffing if the tuition bill dropped 25
cents?
3. Why can we tell the difference between a 10-and 25-watt bulb, but
have trouble distinguishing between a 200-and a 185-watt bulb?
Note: Price Elasticity (€) is a property of the good or service in question.
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Diagnostic Quiz
Price
A
C
B
D3
D1
D2
Quantity
Problem: Most people think that price elasticity is related only to the slope of the
demand function.
Quiz
1. Demand D1 is less elastic at point B than is demand D2----2. Demand D2 has the same elasticity at B that demand D3 has at point C
3. Demand curve D1 has the same elasticity at A and B
4. Point A of Demand D1 is definitely less elastic than point C on Demand D3
5. Point C on Demand D3 is elastic.
Idea: Both the slope and location are important in determining price elasticity!
Method I: The Point-Slope Method
PA
1
or at A,  A  Q *( Slope )
A
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Figure 4.21: Two Important Polar Cases
The denominator (% change
in P) changes but the
numerator does!
The denominator (% change in
Q)doesn’t change but the numerator
does!
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Price Elasticity and the Total Revenue Relationship
 A price reduction will increase total revenue if and
only if the absolute value of the price elasticity of
demand is greater than 1.
 An increase in price will increase total revenue if
and only if the absolute value of the price elasticity
is less than 1.
 An increase in price (around a fat point) will leave
total revenue unchanged if the absolute value of
price elasticity is unity.
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Figure 4.23: The Effect on Total Expenditure of a
Reduction in Price
∆TR = ∆PQ + P∆Q + ∆P∆Q
(E) (G)
0
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Figure 4.24: Demand and Total Expenditure
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Determinants of Price Elasticity of Demand
 Substitution possibilities: the substitution effect of a price
change tends to be small for goods with no close substitutes.
 Budget share: the larger the share of total expenditures
accounted for by the product, the more important will be
the income effect of a price change.
 Direction of income effect: a normal good will have a higher
price elasticity than an inferior good.
 Time: demand for a good will be more responsive to price in
the long-run than in the short-run.
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Figure A4.2: The Segment-Ratio Method
Suppose EC = 1.8, AC =0.88. Thus εC= 1.8/0.88 = 2.05 > 1: Elastic
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