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Topics to be Discussed

Topics to be Discussed. Individual Demand Income and Substitution Effects Market Demand Consumer Surplus Empirical Estimation of Demand. Assume: I = $20 P C = $2 P F = $2, $1, $.50. 10. 6. A. U 1. D. 5. Three separate indifference curves are tangent to each budget line.

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Topics to be Discussed

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  1. Topics to be Discussed • Individual Demand • Income and Substitution Effects • Market Demand • Consumer Surplus • Empirical Estimation of Demand Lecture 4

  2. Assume: • I = $20 • PC = $2 • PF = $2, $1, $.50 10 6 A U1 D 5 Three separate indifference curves are tangent to each budget line. B 4 U3 U2 4 12 20 Effect of a Price Change Clothing (units per month) Food (units per month) Lecture 4

  3. Effect of a Price Change The price-consumption curve traces out the utility maximizing market basket for the various prices for food. Clothing (units per month) 6 A Price-Consumption Curve U1 D 5 B 4 U3 U2 Food (units per month) 4 12 20 Lecture 4

  4. Individual Demand relates the quantity of a good that a consumer will buy to the price of that good. E $2.00 G $1.00 Demand Curve $.50 H 4 12 20 Effect of a Price Change Price of Food Food (units per month) Lecture 4

  5. Income-Consumption Curve 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) Lecture 4

  6. 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. Food (units per month) Lecture 4

  7. Individual Demand Normal Good vs. Inferior Good • 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. Lecture 4

  8. Individual Demand Normal Good vs. Inferior Good • Income Changes • 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. Lecture 4

  9. 15 Income-Consumption Curve Both hamburger and steak behave as a normal good, between A and B... C 10 U3 …but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. B 5 U2 A U1 5 10 20 30 An Inferior Good Steak (units per month) Hamburger (units per month) Lecture 4

  10. Consumer Expendituresin the United States Entertainment 700 947 1274 1514 2054 2654 4300 Owned Dwellings 1116 1725 2253 3243 4454 5793 9898 Rented Dwellings 1957 2170 2371 2536 2137 1540 1266 Health Care 1031 1697 1918 1820 2052 2214 2642 Food 2656 3385 4109 4888 5429 6220 8279 Clothing 859 978 1363 1772 1778 2614 3442 Income Group (1997 $) Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above

  11. Individual Demand Substitutes and Complements 1) Two goods are considered substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other. • e.g. movie tickets and video rentals Lecture 4

  12. Individual Demand Substitutes and Complements 2) Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other. • e.g. gasoline and motor oil Lecture 4

  13. Individual Demand Substitutes and Complements 3) Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other Lecture 4

  14. Income and Substitution Effects • A fall in the price of a good has two effects: Substitution & Income • Substitution Effect • Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive. Lecture 4

  15. Income and Substitution Effects • A fall in the price of a good has two effects: Substitution & Income • Income Effect • Consumers experience an increase in real purchasing power when the price of one good falls. Lecture 4

  16. 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 of the item demanded. Lecture 4

  17. 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. Lecture 4

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

  19. 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 Lecture 4

  20. 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 Lecture 4

  21. 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. Lecture 4

  22. Market Demand From Individual to 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. Lecture 4

  23. Determining the Market Demand Curve Price Individual A Individual B Individual C Market ($) (units) (units) (units) (units) 1 6 10 16 32 2 4 8 13 25 3 2 6 10 18 4 0 4 7 11 5 0 2 4 6 Lecture 4

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

  25. Market Demand • Point Elasticity of Demand • Point elasticity measures elasticity at a point on the demand curve. • Its formula is: Lecture 4

  26. Market Demand • Problems Using Point Elasticity • We may need to calculate price elasticity over portion of the demand curve rather than at a single point. • The price and quantity used as the base will alter the price elasticity of demand. Lecture 4

  27. Market Demand Point Elasticity of Demand (An Example) • Assume • Price increases from 8$ to $10 quantity demanded falls from 6 to 4 • Percent change in price equals: $2/$8 = 25% or $2/$10 = 20% • Percent change in quantity equals: -2/6 = -33.33% or -2/4 = -50% Lecture 4

  28. Market Demand Point Elasticity of Demand (An Example) • Elasticity equals: -33.33/.25 = -1.33 or -.50/.20 = -2.54 • Which one is correct? Lecture 4

  29. Market Demand • Arc Elasticity of Demand • Arc elasticity calculates elasticity over a range of prices • Its formula is: Lecture 4

  30. Market Demand • Arc Elasticity of Demand (An Example) Lecture 4

  31. The Aggregate Demand For Wheat An Example: • The demand for U.S. wheat is comprised of domestic demand and export demand. Lecture 4

  32. The Aggregate Demand For Wheat • The domestic demand for wheat is given by the equation: • QDD = 1700 - 107P • The export demand for wheat is given by the equation: • QDE = 1544 - 176P Lecture 4

  33. The Aggregate Demand For Wheat • Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4). Lecture 4

  34. Total world demand is the horizontal sum of the domestic demand AB and export demand CD. A C E Total Demand Export Demand Domestic Demand F D B The Aggregate Demand For Wheat Price ($/bushel) 20 18 16 14 12 10 8 6 4 2 Wheat(million bushels/yr.) 0 1000 2000 3000 4000 Lecture 4

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

  36. The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Market Price Consumer Surplus Price ($ per ticket) 20 19 18 17 16 Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 15 14 13 Rock Concert Tickets 0 1 2 3 4 5 6 Lecture 4

  37. Consumer Surplus Market Price Demand Curve Actual Expenditure Consumer Surplus Price ($ per ticket) Consumer Surplus for the Market Demand 20 19 18 17 16 15 14 13 Rock Concert Tickets 0 1 2 3 4 5 6 Lecture 4

  38. Consumer Surplus • Combining consumer surplus with the aggregate profits that producers obtain we can evaluate: 1) Costs and benefits of different market structures 2) Public policies that alter the behavior of consumers and firms Lecture 4

  39. The Value of Clean Air An Example: • Air is free in the sense that we don’t pay to breathe it. • The Clean Air Act was amended in 1970. • Question: Were the benefits of cleaning up the air worth the costs? Lecture 4

  40. The Value of Clean Air • People pay more to buy houses where the air is clean. • Data for house prices among neighborhoods of Boston and Los Angeles were compared with the various air pollutants. Lecture 4

  41. Value ($ per pphm of reduction) The shaded area gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrous oxide at a cost of $1000 per part reduced. 2000 A 1000 NOX (pphm) Pollution Reduction 0 5 10 Valuing Cleaner Air Lecture 4

  42. Empirical Estimation of Demand • The most direct way to obtain information about demand is through interviews where consumers are asked how much of a product they would be willing to buy at a given price. • Problem. Consumers may lack information or interest, or be mislead by the interviewer. Lecture 4

  43. Empirical Estimation of Demand • In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed. Lecture 4

  44. Empirical Estimation of Demand • The Statistical Approach to Demand Estimation • Properly applied, the statistical approach to demand estimation can enable one to sort out the effects of variables on the quantity demanded of a product. • “Least-squares” regression is one approach. Lecture 4

  45. Demand Data for Raspberries Year Quantity (Q) Price (P) Income(I) 1988 4 24 10 1989 7 20 10 1990 8 17 10 1991 13 17 17 1992 16 10 17 1993 15 15 17 1994 19 12 20 1995 20 9 20 1996 22 5 20 Lecture 4

  46. D represents demand if only P determines demand and then from the data: Q=28.2-1.00P d1 d2 D d3 Estimating Demand Price 25 20 15 10 5 Quantity 0 5 10 15 20 25 Lecture 4

  47. Price 25 d1,d2,d3represent the demand for each income level. Including income in the demand equation: Q = a - bP + cI or Q = 8.08 - .49P + .81I 20 15 d1 10 d2 D 5 d3 Quantity 0 5 10 15 20 25 Estimating Demand Adjusting for changes in income Lecture 4

  48. Empirical Estimation of Demand Estimating Elasticities • Assuming: Price & income elasticity are constant • The isoelastic demand = • The slope, -b = price elasticity of demand • Constant, c = income elasticity Lecture 4

  49. Empirical Estimation of Demand Estimating Elasticities • Using the Raspberry data: • Price elasticity = -0.24 (Inelastic) • Income elasticity = 1.46 Lecture 4

  50. Empirical Estimation of Demand Estimating Complements and Substitutes • Substitutes: b2is positive • Complements: b2is negative Lecture 4

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