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Chapter 4 Individual and Market Demand

Question: l Why is the Demand Curve downward sloping? m Stupid question? m Needs explanation? © 2005 Pearson Education, Inc. Chapter 4 2

Effect of a Price Change Clothing Assume: • I = \$20 • PC = \$2 • PF = \$2, \$1, \$0. 50 10 A 6 U 1 5 Each price leads to different amounts of food purchased D B 4 U 3 U 2 4 © 2005 Pearson Education, Inc. 12 20 Chapter 4 Food (units per month) 3

Effect of a Price Change l By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual Demand Schedule Chapter 4 Q \$2. 00 4 \$1. 00 12 \$0. 50 © 2005 Pearson Education, Inc. P 20 4

Effect of a Price Change Price of Food 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 © 2005 Pearson Education, Inc. 12 20 Chapter 4 Food (units per month) 5

Demand Curves – Important Properties l The level of utility that can be attained changes as we move along the curve. l 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. © 2005 Pearson Education, Inc. Chapter 4 6

Effect of a Price Change Price of Food When the price falls: Pf/Pc & MRS also fall E \$2. 00 • E: Pf/Pc = 2/2 = 1 = MRS • G: Pf/Pc = 1/2 =. 5 = MRS • H: Pf/Pc =. 5/2 =. 25 = MRS G \$1. 00 \$. 50 H 4 © 2005 Pearson Education, Inc. 12 Demand Curve 20 Chapter 4 Food (units per month) 7

Effects of Income Changes Clothing (units per month) Assume: Pf = \$1, Pc = \$2 I = \$10, \$20, \$30 7 D 5 U 3 An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. U 2 B 3 U 1 A 4 © 2005 Pearson Education, Inc. 10 16 Chapter 4 Food (units per month) 8

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. E \$1. 00 G H D 3 D 2 D 1 4 © 2005 Pearson Education, Inc. 10 16 Chapter 4 Food (units per month) 9

Individual Demand l Engel Curves m Engel curves relate the quantity of good consumed to income. m If the good is a normal good, the Engel curve is upward sloping. m If the good is an inferior good, the Engel curve is downward sloping. © 2005 Pearson Education, Inc. Chapter 4 10

Engel Curves Income 30 (\$ per month) Engel curves slope upward for normal goods. 20 10 4 © 2005 Pearson Education, Inc. 8 12 Chapter 4 16 Food (units per month) 11

Income and Substitution Effects l A change in the price of a good has two effects: m. Substitution Effect m. Income Effect © 2005 Pearson Education, Inc. Chapter 4 12

Income and Substitution Effects l Substitution Effect m. Relative price of a good changes when price changes m. Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive. © 2005 Pearson Education, Inc. Chapter 4 13

Income and Substitution Effects l Income Effect m. Consumers experience an increase in real purchasing power when the price of one good falls. © 2005 Pearson Education, Inc. Chapter 4 14

Income and Substitution Effects l Substitution Effect m. 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. m. When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good. © 2005 Pearson Education, Inc. Chapter 4 15

Income and Substitution Effects l Income Effect m. 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. m. When a person’s income increases, the quantity demanded for the product may increase or decrease. © 2005 Pearson Education, Inc. Chapter 4 16

Income and Substitution Effects l Income Effect m. Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect. © 2005 Pearson Education, Inc. Chapter 4 17

Income and Substitution Effects: Normal Good Clothing (units per month) R When the price of food falls, consumption increases by F 1 F 2 as the consumer moves from A to B. The substitution effect, F 1 E, (from point A to D), changes the A relative prices but keeps real income (satisfaction) constant. C 1 D C 2 B U 2 Substitution Effect O F 1 © 2005 Pearson Education, Inc. Total Effect The income effect, EF 2, ( from D to B) keeps relative prices constant but increases purchasing power. U 1 E S Chapter 4 F 2 T Income Effect Food (units per month) 18

Income and Substitution Effects: Inferior Good Clothing (units per month) R Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. A B U 2 D Substitution Effect O F 1 Total Effect © 2005 Pearson Education, Inc. U 1 E S F 2 Chapter 4 Income Effect T Food (units per month) 19

Income and Substitution Effects l A Special Case--The Giffen Good m. The income effect may theoretically be large enough to cause the demand curve for a good to slope upward. m. This rarely occurs and is of little practical interest. © 2005 Pearson Education, Inc. Chapter 4 20

Market Demand l Market Demand Curves m. A curve that relates the quantity of a good that all consumers in a market buy to the price of that good. m. The sum of all the individual demand curves in the market © 2005 Pearson Education, Inc. Chapter 4 21

Determining the Market Demand Curve Price A B C Market Demand 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 © 2005 Pearson Education, Inc. Chapter 4 22

Summing to Obtain a Market Demand Curve Price 5 The market demand curve is obtained by summing the consumer’s demand curves 4 3 Market Demand 2 1 0 DA 5 © 2005 Pearson Education, Inc. DB 10 DC 15 Chapter 4 20 25 30 Quantity 23

Market Demand l From this analysis one can see two important points m. The market demand will shift to the right as more consumers enter the market. m. Factors that influence the demands of many consumers will also affect the market demand. © 2005 Pearson Education, Inc. Chapter 4 24

Consumer Surplus l Why do consumers exchange 1, 000 Won for an apple? m. Consumers buy goods because it makes them better off m. Consumer Surplus measures how much better off they are © 2005 Pearson Education, Inc. Chapter 4 25

Consumer Surplus l The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid. © 2005 Pearson Education, Inc. Chapter 4 26

Consumer Surplus - Example l Student wants to buy concert tickets l Demand curve tells us willingness to pay for each concert ticket m 1 st ticket worth \$20 but price is \$14 so student generates \$6 worth of surplus m. Can measure this for each ticket m. Total surplus is addition of surplus for each ticket purchased © 2005 Pearson Education, Inc. Chapter 4 27

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 15 14 Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 13 0 Market Price Will not buy more than 7 because surplus is negative 1 © 2005 Pearson Education, Inc. 2 3 4 Chapter 4 5 6 Rock Concert Tickets 28

Consumer Surplus Price (\$ per ticket) Consumer Surplus for the Market Demand 20 19 CS = ½ (\$20 - \$14)*(1600) = \$19, 500 18 17 16 15 13 Consumer Surplus 14 Market Price Demand Curve Actual Expenditure 0 1 © 2005 Pearson Education, Inc. 2 3 4 Chapter 4 5 6 Rock Concert Tickets 29

Network Externalities l Up to this point we have assumed that people’s demands for a good are independent of one another. l For some goods, one person’s demand also depends on the demands of other people © 2005 Pearson Education, Inc. Chapter 4 30

Network Externalities l 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. l Negative network externalities are just the opposite. © 2005 Pearson Education, Inc. Chapter 4 31

Network Externalities l The Bandwagon Effect m. This is the desire to be in style, to have a good because almost everyone else has it, or to indulge in a fad. m. This is the major objective of marketing and advertising campaigns (e. g. toys, clothing). © 2005 Pearson Education, Inc. Chapter 4 32

Positive Network Externality: Bandwagon Effect Price (\$ per unit) D 20 20 © 2005 Pearson Education, Inc. D 40 D 60 D 80 D 100 40 60 Chapter 4 80 When consumers believe more people have purchased the product, the demand curve shifts further to the right. 100 Quantity (thousands per month) 33

Positive Network Externality: Bandwagon Effect Price (\$ per unit) D 20 D 40 D 60 D 80 D 100 The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic. Demand 20 © 2005 Pearson Education, Inc. 40 60 Chapter 4 80 100 Quantity (thousands per month) 34

Positive Network Externality: Bandwagon Effect Price (\$ per unit) D 20 D 40 D 60 D 80 D 100 \$30 Suppose more people buy But as the price falls from \$30 to \$20. becomes the good, it If there were no bandwagon and stylish to own it effect, quantity demanded would the quantity demanded only increase tofurther. increases 48, 000 Demand \$20 Bandwagon Effect Pure Price Effect 20 © 2005 Pearson Education, Inc. 40 48 60 Chapter 4 80 100 Quantity (thousands per month) 35

Network Externalities l The Snob Effect m. If the network externality is negative, a snob effect exists. l The snob effect refers to the desire to own exclusive or unique goods. l The quantity demanded of a “snob” good is higher the fewer the people who own it. © 2005 Pearson Education, Inc. Chapter 4 36

Network Externality: Snob Effect Price (\$ per unit) Demand \$30, 000 Originally demand is D 2, when consumers think 2000 people have bought a good. However, if consumers think 4, 000 people have bought the good, demand shifts from D 2 to D 6 and its snob value has been reduced. \$15, 000 D 2 Pure Price Effect D 4 D 8 2 © 2005 Pearson Education, Inc. 4 6 8 Chapter 4 D 6 14 Quantity (thousands per month) 37

Network Externality: Snob Effect Price (\$ per unit) 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. Demand \$30, 000 Net Effect Snob Effect \$15, 000 D 2 Pure Price Effect D 4 D 8 2 © 2005 Pearson Education, Inc. 4 6 8 Chapter 4 D 6 14 Quantity (thousands per month) 38