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Chapter 4

Chapter 4. Individual and Market Demand. Topics to be Discussed. Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Network Externalities. Individual Demand.

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Chapter 4

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  1. Chapter 4 Individual and Market Demand

  2. Topics to be Discussed • Individual Demand • Income and Substitution Effects • Market Demand • Consumer Surplus • Network Externalities Chapter 4

  3. Individual Demand • Demand curve can be derived from consumption choices made by consumer who is faced with budget constraint • Price Changes • The impact of a change in the price 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 • When there is a decrease in price, the budget line will rotate outward (Q↑), while when the price increase the budget line will rotate inward (↓Q). Chapter 4

  4. Change in price (price effect and the demand curve) Q cloth 1. Assume Y= $20, Pc = $2 and Pf = $2, $1 and 0.50. 2. Initial equilibrium = A, consume 6C and 4F 3. Suppose there is a fall in the price of food from $2 to $1 (Pc unchanged) 4. Lower Pf  rotates the budget line outward  new equilibrium at B (consume 4C & 12F) 5. Suppose Pf reduce to $0.50, budget line rotates outward further  new equilibrium at C (consume 3C & 20F) 6. The equilibrium points A, B and C used to derive demand curve for food. 7. At every point on DD curve – consumer is maximizing utility by satisfying MRS = Pf/Pc Price-consumption curve 6 ●A I1 ●B 4 ●C 3 I2 I3 20 12 4 Q food P food ●A’ $2 ●B’ $1 ●C’ .50 DD 12 4 20 Q food Chapter 4

  5. Individual Demand Curves – Important Properties • The level of utility changes as we move along the curve (the lower the price of product, the higher the consumer’s purchasing power and the higher its level of utility). • At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS = Pf / Pc . • If the price consumption curve is downward-sloping, the two goods are considered substitutes. • If the price consumption curve is upward-sloping, the two goods are considered complements. Chapter 4

  6. 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

  7. Individual Demand • Income Changes • Changing income, with prices fixed, causes consumer to change their market baskets. • An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve. • Simultaneously, the increase in income shifts the demand curve to the right. • The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level. Chapter 4

  8. Income changes (income effect & change in demand) 1. Assume Pc = $1 and Pf = $2, $1 and Y= $10, $20 and $30 2. Initial equilibrium = A, consume 3C and 4F 3. Suppose there is a  in the income from $10 to $20  there will be a parallel shift outward of budget line  new equilibrium at B (consume 5C & 10F) 4. Suppose Y  to $30  budget line shifts outward again  new equilibrium at C (consume 7C & 16F) 5. Higher income implies consumer will increase their consumption of both goods 6. The effect of income changes are shown with a shift of demand curve to right. Q cloth income-consumption curve 7 ●C 5 I3 ●B ●A 3 I2 I1 16 Q food 10 4 P food ●B’ ●A’ ●C’ $2 D3 D1 D2 10 16 4 Q food Chapter 4

  9. Normal versus Inferior • 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. Chapter 4

  10. Steak 5 U2 B 3 U1 A 4 10 Effects of Income Changes on inferior goods 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. Hamburger is a normal good between point A and B. But becomes an inferior good when the income consumption curve bends backward between B and C. ● C U3 Hamburger Chapter 4

  11. Engel Curves • Income-consumption curves can be used to construct 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. Chapter 4

  12. 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

  13. Income ($ per month) 30 20 10 Hamburger 4 8 12 16 Engel Curves ●C Inferior ●B Normal ●A Chapter 4

  14. Income and Substitution Effects • A change in the price of a good has two effects: i. 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. ii. 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. 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 Substitution Effects: Normal Good Clothing (units per month) Food (units per month) O Chapter 4

  18. 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 Substitution Effects: Inferior Good Clothing (units per month) R A D Substitution Effect U1 Food (units per month) O F1 E S F2 T Chapter 4

  19. 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. • Giffen good – good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect Chapter 4

  20. Income and Substitution Effects: Giffen Good Clothing (units per month) Substitution effect = EF2 Income effect = F1 F2 Total effect = F1 E IE > SE R B U2 A D Substitution Effect U1 Food (units per month) O F1 E F2 S T Income Effect 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 • Market demand curve will shift to the right as more consumer enter market • Factors that influence the demands of many consumers will also affect market demand. 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. Consumer Surplus • Consumers buy goods because it makes them better off • Consumer Surplus measures how much better off they are • It is a difference between what a consumer is willing to pay for a good and the amount they actually paid Chapter 4

  25. Market Price Consumer Surplus: Example • Demand curve shows the willingness to pay for each concert ticket • 1st ticket worth $20 but price is $14 so consumer generates $6 worth of surplus • 2nd ticket worth $19 but market P= $14, consumer surplus =$5 • 3rd ticket = $18, Market p=$14, so CS = $4………..=21 • Will not buy more than 7 ticket because surplus is negative • Thus, total surplus is addition of surplus for each ticket purchased 20 19 18 17 16 Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 15 14 13 2 0 3 4 5 6 1 Chapter 4 Concert Tickets

  26. Consumer Surplus • The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller. • Consumer surplus is area under the demand curve and above the price Chapter 4

  27. Market Price Demand Curve Actual Expenditure = $14 X 6500 = $91,000 Consumer Surplus Price ($ per ticket) Consumer Surplus for the Market Demand 20 19 CS = ½ ($20 - $14)*(6500) = $19,500 18 17 16 Consumer Surplus 15 14 13 0 1 2 3 4 5 6 Concert Tickets (thousand) Chapter 4

  28. Network Externalities • So far we assumed that people’s demands for a good are independent of one another • For instance, Tom’s demand for pizza depends on Tom’s tastes, income, the price of coffee, price of other goods, etc – based on this we derived market demand curve simply by summing individuals’ demands • For some goods, one person’s demand also depends on the demands of other people, whereby a person’s demand may be affected by the number of other people who have purchased the good • This is called as Network Externalities Chapter 4

  29. Network Externalities • Network externalities can be positive (bandwagon effect) or negative (snob effect) • A positive externality exists of the quantity of a good demanded by a typical consumer increases in response to the growth in purchases of other consumers • If the quantity demanded decreases, there is a negative network externality Chapter 4

  30. Bandwagon effect • Bandwagon effect - the desire to possess a good because everyone else has it • Suppose initially people think that only 20,000 people (D20) bought certain good • If they think that 40,000 people have bought the good because it is attractive, so demand = D40 ……until D100 Chapter 4

  31. D20 D40 D60 D80 D100 $30 Pure Price Effect 20 40 60 80 100 Positive NetworkExternality: Bandwagon Effect (BE) • However the demand depends on Price. If P=$30, 40,000 people will buy (D40) • If P=$20, 80,000 people will buy (D 80) • So the market demand curve derived by joining the points on the curves (D20,D40,D60, D80 and D100) • Market DD curve is relatively elastic because a decrease of price from $30 to $20 causes the demand shift from D40 to D80 • Without BE, Qd increase from 40,000 to 48,000 • As more people buy, BE increases the Qd further to 80,000 Price ($ per unit) $20 D 48 Quantity (thousands per month)

  32. Network Externalities (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. • The quantity of a good demanded falls in response to the growth of purchases by other individuals Chapter 4

  33. 1. If consumer believe only 2,000 people owned certain good, the demand curve = D2 2. If they believe 4,000 own the good, it has become less exclusive so its snob value is reduced, thus Qd will be lower (D4) 3. Similarly if the consumers believe that 6,000 people own the good, demand is even smaller (D6) 4. Market DD – joining the points on curves D2, D4, D6 and D8 5. SE makes the market DD less elastic. Why? 6. When P=$30,000, 2000 people purchase the good. 7. When the price lowered to $15,000, without SE, Q purchased will increase to 14,000 (D2) 8. As a snob product its value is greatly reduced as more people own it 9. Thus SE reduces the increase in Q to 6,000 Snob Effect (SE) Price Demand ● 30,000 ● ● ● 15,000 D2 D4 ● D6 D8 4 6 8 14 2 Quantity (‘000) Net effect Snob effect Pure Price Effect Chapter 4

  34. Summary • Individual Demand • Effects of price and income changes • price consumption curve and income consumption curve • Engel curves : normal and inferior • Income and Substitution Effects • Normal, inferior and giffen goods • Market Demand • Consumer Surplus • Network Externalities • Bandwagon effect and snob effect Chapter 4

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