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Chapter 4

Chapter 4. Individual and Market Demand. Question:. Why is the Demand Curve downward sloping? Stupid question? Needs explanation?. Clothing. 10. 6. A. D. 5. U 1. B. 4. U 3. U 2. Food (units per month). 12. 20. 4. Effect of a Price Change. Assume: I = $20 P C = $2

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Chapter 4

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  1. Chapter 4 Individual and Market Demand

  2. Question: • Why is the Demand Curve downward sloping? • Stupid question? • Needs explanation? Chapter 4

  3. Clothing 10 6 A D 5 U1 B 4 U3 U2 Food (units per month) 12 20 4 Effect of a Price Change • Assume: • I = $20 • PC = $2 • PF = $2, $1, $0.50 Each price leads to different amounts of food purchased Chapter 4

  4. 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 Chapter 4

  5. 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. Chapter 4

  6. 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. Chapter 4

  7. 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 Chapter 4

  8. Clothing (units per month) 7 D U3 5 U2 B 3 U1 A Food (units per month) 4 10 16 Effects of Income Changes 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. Chapter 4

  9. E G H $1.00 D3 D2 D1 4 10 16 Effects of Income Changes Price of food An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right as well. Food (units per month) Chapter 4

  10. Individual Demand • 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. Chapter 4

  11. Income ($ per month) 30 20 10 Food (units per month) 4 8 12 16 Engel Curves Engel curves slope upward for normal goods. Chapter 4

  12. Income and Substitution Effects • A change in the price of a good has two effects: • Substitution Effect • Income Effect Chapter 4

  13. 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. Chapter 4

  14. Income and Substitution Effects • Income Effect • Consumers experience an increase in real purchasing power when the price of one good falls. Chapter 4

  15. Income and Substitution Effects • 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. Chapter 4

  16. Income and Substitution Effects • 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. Chapter 4

  17. Income and Substitution Effects • Income Effect • Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect. Chapter 4

  18. 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) O Chapter 4

  19. 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 A D Substitution Effect U1 Food (units per month) O F1 E S F2 T Chapter 4

  20. 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

  21. Market 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. • The sum of all the individual demand curves in the market Chapter 4

  22. Determining the Market Demand Curve Chapter 4

  23. Price 5 4 3 Market Demand 2 1 DA DB DC 0 Summing to Obtain aMarket Demand Curve The market demand curve is obtained by summing the consumer’s demand curves Quantity 5 10 15 20 25 30 Chapter 4

  24. Market Demand • From this analysis one can see two important points • The market demand will shift to the right as more consumers enter the market. • Factors that influence the demands of many consumers will also affect the market demand. Chapter 4

  25. Consumer Surplus • Why do consumers exchange 1,000 Won for an apple? • Consumers buy goods because it makes them better off • Consumer Surplus measures how much better off they are Chapter 4

  26. Consumer Surplus • The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid. Chapter 4

  27. Consumer Surplus - Example • Student wants to buy concert tickets • Demand curve tells us willingness to pay for each concert ticket • 1st ticket worth $20 but price is $14 so student generates $6 worth of surplus • Can measure this for each ticket • Total surplus is addition of surplus for each ticket purchased Chapter 4

  28. Market Price Consumer Surplus - Example Price ($ per ticket) The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. 20 19 18 17 16 Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 15 14 13 Will not buy more than 7 because surplus is negative Rock Concert Tickets 0 1 2 3 4 5 6 Chapter 4

  29. Market Price Demand Curve Actual Expenditure Consumer Surplus Price ($ per ticket) Consumer Surplus for the Market Demand 20 19 CS = ½ ($20 - $14)*(1600) = $19,500 18 17 16 Consumer Surplus 15 14 13 0 1 2 3 4 5 6 Rock Concert Tickets Chapter 4

  30. Network Externalities • Up to this point we have assumed that people’s demands for a good are independent of one another. • For some goods, one person’s demand also depends on the demands of other people Chapter 4

  31. 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

  32. 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

  33. D20 D40 D60 D80 D100 20 40 60 80 100 Positive NetworkExternality: Bandwagon Effect Price ($ per unit) When consumers believe more people have purchased the product, the demand curve shifts further to the the right . Quantity (thousands per month) Chapter 4

  34. D20 D40 D60 D80 D100 20 40 60 80 100 Positive NetworkExternality: Bandwagon Effect Price ($ per unit) The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic. Demand Quantity (thousands per month) Chapter 4

  35. D20 D40 D60 D80 D100 $30 $20 Bandwagon Effect Pure Price Effect 20 40 60 80 100 48 Positive NetworkExternality: Bandwagon Effect Price ($ per unit) Suppose the price falls from $30 to $20. If there were no bandwagon effect, quantity demanded would only increase to 48,000 But as more people buy the good, it becomes stylish to own it and the quantity demanded increases further. Demand Quantity (thousands per month) Chapter 4

  36. 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

  37. Demand However, if consumers think 4,000 people have bought the good, demand shifts from D2 to D6 and its snob value has been reduced. Pure Price Effect D4 D6 D8 4 6 8 Network Externality: Snob Effect Price ($ per unit) Originally demand is D2, when consumers think 2000 people have bought a good. $30,000 $15,000 D2 Quantity (thousands per month) 2 14 Chapter 4

  38. Snob Effect Net Effect Price ($ per unit) Demand $30,000 $15,000 D2 Pure Price Effect D4 D6 D8 Quantity (thousands per month) 2 4 6 8 14 Network Externality: Snob Effect The demand is less elastic and as a snob good its value is greatly reduced if more people own it. Sales decrease as a result. Examples: Rolex watches and long lines at the ski lift. Chapter 4

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