Consumer demand

1. Consumer demand From the optimal choice of a consumer to overall market demand

2. Consumer demand • Up until now, we’ve examined how a single consumer chooses the best (most satisfying) bundle out of the set of affordable ones • The next step is to derive the demand function for each good: • What amount of each good is chosen for each level of its price? • Then, we need to see how all the individual demand functions add up to the market demand for that good

3. Consumer demand Deriving consumer demand From individual to market demand Elasticities

4. Deriving consumer demand • As we have seen, given a stable set of preferences, the amount of a good chosen in a bundle depends on : • The price of the good • The price of other goods • The income of the agent • The quantity demanded by the ith agent is therefore a function of these three variables

5. Deriving consumer demand • The effects of a change of income on demand: • The demand for normal goods increases when income increases • Some goods are inferior : The demand for these goods decreases when income increases • If one plots all the quantities demanded for each level of income, one gets the Engel curve

6. C B    A Deriving consumer demand Income expansion path Good 1 Good 2

7. 150 E’3 100 E’1 50 E’2 Demand for DVDs Deriving consumer demand Other goods E3 E1 E2 DVD Income Engel curve

8. Deriving consumer demand Engel curves Demand Demand Income Income Inferior good Normal good

9. Deriving consumer demand • The effects of a change of price on demand • Generally, because of the substitution effect, the demand for agood varies inversely with its price • Some goods are Giffen goods : The demand for these goods varies in the same direction as price (income effect) • If one plots all the quantities demanded for each level of price, one gets the Demand curve

10. Good1 A  C B   Good 2 Deriving consumer demand Price expansion path

11. E’2 40 E’1 20 E’3 10 Demand for DVDs Deriving consumer demand Other goods E3 E1 E2 DVD Price of DVDs Demand curve

12. Deriving consumer demand A typical demand curve: Price1 If the price falls, the individual demands more of the good Demandof agent i

13. Deriving consumer demand • IMPORTANT NOTE: • The demand function depends on • The price of the good • The price of other goods • The income of the agent • The demand curve only shows a relation between demand and the price of the good • So how do the other variables (income, the price of other goods) affect the demand curve?

14. Deriving consumer demand The effect of income changes on the demand curve Price1 If the income increases, the demand increases (at constant price) If the income falls, the demand falls (at constant price) Demandof agent i

15. Deriving consumer demand The effect of a change in another price on the demand curve... ... is ambiguous !! Price1 It depends on the relative size of the income and substitution effects (Of opposite directions here) This in turn depends on whether the 2 goods are substitutes or complements Demandof agent i

16. Consumer demand Deriving consumer demand From individual to market demand Elasticities

17. From individual to market demand • Market demand is the aggregate quantity demanded at a given price level • It is not the demand of a single individual, but that of all the agents in the economy • The market demand for a good depends on the relative price of that good and the distribution of all the incomes in the economy

18. From individual to market demand A simple 2-agent example Price Market demand Agent 1’s demand Agent 2’s demand

19. From individual to market demand A Market demand curve Price1 If the price falls, the market demand for the good increases Market Demand

20. Consumer demand Deriving consumer demand From individual to market demand Elasticities

21. Elasticities • The concept of an elasticity is central to microeconomic theory : • Up until now, we have reasoned in qualitative terms. • A demand curve is downward sloping • It moves upwards if income increases • If we want our theory to be useful in the real world, we need to quantifythese concepts. • How sensitive is demand to price /Income ? • Is this the same for all goods ?

22. Elasticities • An elasticity is a measure of this sensitivity • It gives the % change in one variable following a % change in another variable • Example : The price elasticity of demand • A price elasticity of demand of -0.5: • An increase in price of 1 % ⇒ fall in demand of 0.5 % • An increase in price of 10 % ⇒ fall in demand of 5 %

23. Elasticities • The percentage change of a function is defined as: • This means that we can express the elasticity as: Slope of the demand function Price/Demand ratio

24. Price Quantity Elasticities Price elasticity of a linear demand curve Slope of the demand function Price/Demand ratio p ∂p ∂Qd Demand Qd

25. Elasticities • The demand function has 3 variables: • We now have measure of sensitivity for all these variables: • The price of the good • Price elasticity of demand (which you already know) • The price of other goods • Cross price elasticity of demand • The income of the agent • Income elasticity of demand

26. Elasticities • The price elasticity of demand: • Is negative in general • An increase in price reduces the quantity demanded • Is positive for Giffen goods • Demand is price-elasticif the price elasticity is greater than 1 in magnitude • 10 % increase in price ⇒ >10% fall in demand • Demand is price-inelasticif the price elasticity is smaller than 1 in magnitude • 10 % increase in price ⇒ <10% fall in demand

27. Elasticities • The cross price elasticity of demand • Measures the variation of the quantity demanded following an increase in the price of another good • This gives information on whether the goods are substitutes or complements • Example : what is the effect of the increase in fuel prices on the demand for Hummers ??

28. Elasticities • The cross price elasticity of demand • Is negative in for complement goods • Example : ↑price of fuel ⇒ ↓ demand for cars • Is positive for substitute goods • Example : ↑price of coffee ⇒ ↑ demand for tea • The magnitudeof the elasticity gives information on the strength of the link • A large magnitude (>1) means a strong complement / substitute link • A small magnitude (<1) means a weak link • A magnitude close to 0 means no link

29. Elasticities • The income elasticity of demand • measures the variation of the quantity demanded following an increase in income of agents • Is negative in for inferior goods • An increase in income reduces the quantity demanded • Is positive for normal goods • An increase in income increases the quantity demanded • Is greater than one for “luxury” goods • An increase in income increases the quantity demanded more than proportionately