Transcript Regression analysis (econometrics)

MICROECONOMICS: Theory & Applications
Chapter 4: Individual and Market Demand
By
Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
11th Edition, Copyright 2012
PowerPoint prepared by Della L. Sue, Marist College
Learning Objectives

Understand how price changes affect consumption
choices.
 Differentiate between the income and substitution
effects associated with a price change on the
consumption of a particular good.
 Explain the relation between income and substitution
effects in the case of inferior goods.
 Show how individual demand curves are aggregated
to obtain the market demand curve.
(continued)
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Learning Objectives
(continued)

Demonstrate how consumer surplus represents the
net benefit , or gain, served by an individual from
consuming one market basket instead of another.
 Investigate the relationship between own-price
elasticity of demand and the price-consumption curve.
 Examine network effects: the extent to which an
individual consumer’s demand for a good is influenced
by other individuals’ purchases.
 Overview the basics of demand estimation.
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Price Changes and Consumption
Choices

Price-consumption curve: a curve that
identifies the optimal market basket
associated with each possible price of a
good, holding constant all other
determinants of demand.

The consumer’s demand curve can be
derived from the price-consumption curve.
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Figure 4.1 – Derivation of the
Consumer’s Demand Curve
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Some Remarks about the
Demand Curve

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The consumer’s level of well-being varies along the demand
curve.
The prices of other goods are held constant among a demand
curve, but the quantities purchased of these other goods can
vary.
At each point on the demand curve, the consumer’s optimality
condition is satisfied:
MRSXO = PX/PO
where “O” refers to “other goods” (composite good).
The demand curve identifies the marginal benefit associated with
various levels of consumption.
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Figure 4.2 - Do Demand Curves Always
Slope Downward?
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Income and Substitution Effects of a
Price Change

Income effect – a change in a consumer’s real
purchasing power brought about by a change
in the price of a good

Substitution effect – an incentive to increase
consumption of a good whose price falls, at
the expense of other, now relatively more
expensive, goods
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Income and Substitution Effects Illustrated:
The Normal-Good Case
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Substitution Effect: change in consumption due to a
change in relative prices, with no change in real
income or well-being
Income Effect: change in consumption due to a
change in real income or well-being, with no change in
relative prices
For a normal good, both effects imply more
consumption at a lower price and less consumption at
a higher price.
Demand curve slopes downward.
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Figure 4.3 - Income and Substitution Effects of a
Price Reduction: The Normal-Good Case
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The Income and Substitution Effects Associated
with a Gasoline Tax-Plus-Rebate Program
Excise Tax – a tax on a specific good
 Objective: encourage consumers to reduce
their use of gasoline
 What can be done with the tax revenue?
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Tax rebate to consumers
Reduce the government’s outstanding debt
Would an excise tax and a tax rebate curtail
consumption?
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Figure 4.4 - A Graphical Examination of a
Tax-Plus-Rebate Program
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Income and Substitution Effects Illustrated:
Inferior Goods
Two possibilities:
 Substitution effect > income effect

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Demand curve slopes downward
Income effect > substitution effect
Demand curve slopes upward
 Giffen Good

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Figure 4.5 - Income and Substitution Effects
for an Inferior Goods
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From Individual to Market Demand

Horizontal summation: add quantities of individual
demand curves at each price to obtain the market
demand curve

All individual demand curves slope downward =>
market demand curve slopes downward

If some individual demand curves slope upward =>
market demand curve can till slope downward
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Figure 4.6 – Summing Individual Demands
to Obtain Market Demand
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Figure 4.7 - The Aggregate Demand
for a UCLA MBA
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Consumer Surplus

Consumer surplus – a measure of the net gain to consumers
from purchasing a good arising from its cost being below the
maximum that consumers are willing to pay

Total benefit – the total value a consumer derives from a
particular amount of a good and thus the maximum amount the
consumer would be willing to pay for that amount of the good.

Marginal benefit – the incremental value a consumer derives
from consuming an additional unit of a good and thus the
maximum amount the consumer would pay for that additional
unit
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Figure 4. 8 – Consumer Surplus
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Calculating Consumer Surplus
[NOTE: See Figure 4.8]
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Figure 4.9 - Geometric Calculation of
Consumer Surplus
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Figure 4.10 – The Increase in
Consumer Surplus with a Lower Price
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Figure 4.11 - Consumer Surplus and
Indifference Curves
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Figure 4.12 - Price-Consumption Curves
and the Elasticity of Demand
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Network Effects

Network effects – the extent to which an
individual consumer’s demand for a good
is influenced by other individuals’
purchases
Bandwagon effect – a positive network
effect
 Snob effect – a negative network effect

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The Bandwagon Effect

It exists whenever the quantity of a good demanded by a
particular consumer is greater the larger the number of
other consumers purchasing the same good.

It increases the response in quantity demanded to any
change in price

The market demand is more elastic than the individual
demand curves.
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Figure 4.13 - The Bandwagon Effect
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The Snob Effect

It occurs when a consumer is less willing to purchase a
good the more widespread its usage.

The quantity of a good demanded by a particular
individual falls the more widely owned the good is
considered to be by other consumers.

The market demand is more inelastic than the
individual demand curves.
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Figure 4.14 - Snob Effect
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The Basics of Demand Estimation

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Experimentation
 Limitations:
 difficult to allow only one factor to change, holding the
other factors constant
 may be incorrect to apply the results obtained from the
sample to the entire population
Surveys
 Important to choose a representative sample
 Reliability is dependent on respondents’ truthfulness
Regression analysis (econometrics) – a statistical method that
allows one to estimate the sensitivity of the quantity demanded of
a good to determinants such as price and income
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Table 4.1
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Figure 4.15 - Ordinary Least-Squares
Regression
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Regression Analysis
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Deriving the Consumer’s Demand
Curve Mathematically

The demand curve of a consumer can be
derived from the first-order conditions
determining the consumer’s optimal choice:
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solve for the quantity demanded of the product,
as a function of the price
The demand curve depends on the exact
nature of the consumer’s preferences as
expressed in the utility function.
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Deriving the Consumer’s Demand
Curve Mathematically [Equations]
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The Cobb-Douglas Utility Function
[Equations]
[continued]
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The Cobb-Douglas Utility Function
[Equations]
[continued]
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