Individual and market demand chapter 4
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Individual and Market Demand Chapter 4. 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.

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Individual and Market Demand Chapter 4

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Individual and market demand chapter 4

Individual and Market DemandChapter 4


Individual demand

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


Individual and market demand chapter 4

10

6

A

D

5

U1

B

4

U3

U2

12

20

4

Clothing

Assume:

  • I = $20

  • PC = $2

  • PF = $2, $1, $0.50

Each price leads to different amounts of food purchased

Food (units

per month)


Effect of a price change

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.


Effect of a price change1

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:


Effect of a price change2

Price

of Food

E

$2.00

Demand Curve

G

$1.00

$.50

H

Food (units

per month)

4

12

20

Effect of a Price Change

Individual Demand relates

the quantity of a good that

a consumer will buy to the

price of that good.


Demand curves important properties

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


Effect of a price change3

Price

of Food

E

$2.00

G

$1.00

$.50

H

Food (units

per month)

4

12

20

Demand Curve

Effect of a Price Change

When the price falls:

Pf/Pc & MRS also fall

  • E: Pf/Pc = 2/2 = 1 = MRS

  • G: Pf/Pc = 1/2 = .5 = MRS

  • H:Pf/Pc = .5/2 = .25 = MRS


Effects of income changes

7

D

U3

5

U2

B

3

U1

A

4

10

16

Effects of Income Changes

Clothing

(units per

month)

Assume: Pf = $1, Pc = $2

I = $10, $20, $30

An increase in income,

with the prices fixed,

causes consumers to alter

their choice of

market basket.

Food (units

per month)


Income changes

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


Engel curves

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.


Engel curves1

Income

($ per

month)

30

20

10

Food (units

per month)

4

8

12

16

Engel Curves

Engel curves slope

upward for

normal goods.


Substitutes complements

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


Substitutes complements1

Substitutes & Complements

  • A change in the price of a good has two effects:

    • Substitution Effect

    • Income Effect


Income and substitution effects

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.


Individual and market demand chapter 4

  • 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.


Individual and market demand chapter 4

When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.

R

The substitution effect,F1E,

(from point A to D), changes the

relative prices but keeps real income

(satisfaction) constant.

C1

A

The income effect, EF2,

( from D to B) keeps relative

prices constant but

increases purchasing power.

D

B

C2

U2

Substitution

Effect

U1

F1

E

S

F2

T

Total Effect

Income Effect

Income and SubstitutionEffects: Normal Good

Clothing

(units per

month)

Food (units

per month)


Individual and market demand chapter 4

Since food is an

inferior good, the

income effect is

negative. However,

the substitution effect

is larger than the

income effect.

B

U2

Total Effect

Income Effect

Income and SubstitutionEffects: Inferior Good

Clothing

(units per

month)

R

Substitution

Effect

U1

Food (units

per month)

F1

E

S

F2


Market demand

Market Demand

  • Price Elasticity of Demand

    • Measures the percentage change in the quantity demanded resulting from a percent change in price.


Market demand1

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


Market demand2

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


Price elasticity of demand

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)


Example

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


Consumer surplus

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


Consumer surplus1

Market Price

Demand Curve

Actual

Expenditure

Consumer Surplus

Consumer Surplus

for the Market Demand

20

Price

($ per

ticket)

19

CS = ½ ($20 - $14)*(1600) = $19,500

18

17

16

15

14

0

1

2

3

4

5

6

Rock Concert Tickets


Empirical estimation of demand

Empirical Estimation of Demand

  • Estimating Elasticities

    • For the demand equation: Q = a - bP

  • Elasticity:

Assuming: Price & income elasticity are constant

  • The isoelastic demand =

The slope, -b = price elasticity of demand

Constant, c = income elasticity of demand


Using the raspberry data

Using the Raspberry data:

Price elasticity = -0.24 (Inelastic)

Income elasticity = 1.46

  • Substitutes: b2 is positive

  • Complements: b2 is negative


Individual and market demand chapter 4

Price elasticity = -2.0

Income elasticity = 0.62

Cross elasticity = 0.14


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