macroeconomy-pyndic-ch4

7/30/2019 macroeconomy-pyndic-ch4

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Chapter 4

Individual and

Market Demand


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Chapter 4 Slide 2

Topics to be Discussed

Individual Demand

Income and Substitution Effects

Market Demand

Consumer Surplus


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Chapter 4 Slide 3

Topics to be Discussed

Network Externalities

Empirical Estimation of Demand


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Chapter 4 Slide 4

Individual Demand

Price Changes

Using the figures developed in theprevious chapter, the impact of achange in the price of food can beillustrated using indifference curves.


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Chapter 4 Slide 5

Effect of a Price Change

Food (unitsper month)

Clothing

(units permonth)

4

5

6

U2

U3

A

BDU1

4 12 20

Three separateindifference curves

are tangent to

each budget line.

Assume:I =$20PC = $2PF =$2, $1, $.50

10


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Chapter 4 Slide 6

Price-Consumption Curve



Clothing(units per

month)

4

5

6

U2

U3

A

BDU1

4 12 20

The price-consumptioncurve traces out the

utility maximizingmarket basket for the

various prices for food.


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Demand Curve

Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.


Priceof Food

H

E

G

$2.00

4 12 20

$1.00

$.50



Individual Demand

Two Important Properties of Demand

Curves1) The level of utility that can be

attained changes as we move

along the curve.

The Individual Demand Curve



Individual Demand

Two Important Properties of Demand

Curves2) At every point on the demand

curve, the consumer is maximizing

utility by satisfying the condition thatthe MRSof food for clothing equalsthe ratio of the prices of food andclothing.

The Individual Demand Curve





Priceof Food

H

E

G

$2.00

4 12 20

$1.00

$.50

Demand Curve

E: Pf/Pc=2/2 = 1 = MRSG: Pf/Pc=1/2 = .5 = MRSH:Pf/Pc=.5/2 = .25 = MRS

When the price falls: Pf/Pc& MRS also fall



Individual Demand

Income Changes

Using the figures developed in theprevious chapter, the impact of achange in the income can be illustratedusing indifference curves.


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Chapter 4 Slide 12

Effects of Income Changes


Clothing(units per

month)

An increase in income,with the prices fixed,

causes consumers to alter

their choice ofmarket basket.

Income-ConsumptionCurve

3

4

A U1

5

10

B

U2

D7

16

U3

Assume: Pf =$1Pc = $2I =$10, $20, $30


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Chapter 4 Slide 13

Effects of Income Changes


Priceof

food

An increase in income,from $10 to $20 to $30,with the prices fixed,shifts the consumersdemand curve to the right.

$1.00

4

D1

E

10

D2

G

16

D3

H


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Chapter 4 Slide 14

Individual Demand

Income Changes

The income-consumption curve tracesout the utility-maximizing combinations

of food and clothing associated withevery income level.


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Chapter 4 Slide 15

Individual Demand

Income Changes

An increase in income shifts the budgetline to the right, increasing consumption

along the income-consumption curve.

Simultaneously, the increase in incomeshifts the demand curve to the right.


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Chapter 4 Slide 16

Individual Demand

Income Changes

When the income-consumption curvehas a positive slope:

The quantity demanded increaseswith income.

The income elasticity of demand ispositive.

The good is a normal good.

Normal Good vs. Inferior Good


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Chapter 4 Slide 17

Individual Demand

Income Changes

When the income-consumption curvehas a negative slope:

The quantity demanded decreaseswith income.

The income elasticity of demand isnegative.

The good is an inferior good.

Normal Good vs. Inferior Good


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Chapter 4 Slide 18

An Inferior Good

Hamburger(units per month)

Steak(units per

month)

15

30

U3

C

Income-ConsumptionCurve

but hamburgerbecomes an inferior

good when the incomeconsumption curve

bends backwardbetween Band C.

105 20

5

10

AU1

B

U2

Both hamburgerand steak behaveas a normal good,between A and B...


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Chapter 4 Slide 19

Individual Demand

Engel Curves

Engel curves relate the quantity of goodconsumed to income.

If the good is a normal good, the Engelcurve is upward sloping.

If the good is an inferior good, the Engelcurve is downward sloping.


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Chapter 4 Slide 20

Engel Curves


30

4 8 12

10

Income

($ permonth)

20

160

Engel curves slope

upward fornormal goods.


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Chapter 4 Slide 21

Engel Curves

Engel curves slope

backward bendingfor inferior goods.

Inferior

Normal


30

4 8 12

10

Income

($ permonth)

20

160

Consumer Expenditures


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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

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

Income Group (1997 $)


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Chapter 4 Slide 23

Individual Demand

1) Two goods are consideredsubstitutes if an increase(decrease) in the price of oneleads to an increase (decrease) inthe quantity demanded of the

other.

e.g. movie tickets and video rentals

Substitutes and Complements


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Chapter 4 Slide 24

Individual Demand

2) Two goods are consideredcomplements if an increase(decrease) in the price of oneleads to a decrease (increase) inthe quantity demanded of the

other.e.g. gasoline and motor oil



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Chapter 4 Slide 25

Individual Demand

3) Two goods are independent when achange in the price of one good hasno effect on the quantity demandedof the other



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Chapter 4 Slide 26

Individual Demand


If the price consumption curve isdownward-sloping, the two goods are

considered substitutes.

If the price consumption curve isupward-sloping, the two goods are

considered complements.

They could be both!


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Chapter 4 Slide 27


A fall in the price of a good has twoeffects: Substitution & Income

Substitution Effect

Consumers will tend to buy more ofthe good that has become relativelycheaper, and less of the good that is

now relatively more expensive.


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Chapter 4 Slide 28


A fall in the price of a good has twoeffects: Substitution & Income

Income Effect

Consumers experience an increasein real purchasing power when theprice of one good falls.


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Chapter 4 Slide 29


Substitution Effect

The substitution effect is the change inan items consumption associated with

a change in the price of the item, withthe level of utility held constant.

When the price of an item declines, the

substitution effect always leads to anincrease in the quantity of the itemdemanded.


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Chapter 4 Slide 30


Income Effect

The income effect is the change in anitems consumption brought about by

the increase in purchasing power, withthe price of the item held constant.

When a persons income increases, the

quantity demanded for the product mayincrease or decrease.


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Chapter 4 Slide 31


Income Effect

Even with inferior goods, the incomeeffect is rarely large enough to outweigh

the substitution effect.

Income and Substitution


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Chapter 4 Slide 32

Income and SubstitutionEffects: Normal Good

Food (unitsper month)O

Clothing

(units permonth) R

F1 S

C1 A

U1

The income effect, EF2,( from Dto B) keeps relativeprices constant butincreases purchasing power.

Income Effect

C2

F2 T

U2

B

When the price of food falls,consumption increases by F1F2as the consumer moves from Ato B.

ETotal Effect

SubstitutionEffect

D

The substitution effect,F1E,(from point A to D), changes therelative prices but keeps real income

(satisfaction) constant.

Income and Substitution


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Chapter 4 Slide 33


O

R

Clothing

(units permonth)

F1 S F2 T

A

U1

E

SubstitutionEffect

D

Total Effect

Since food is aninferior good, theincome effect is

negative. However,the substitution effect

is larger than theincome effect.

B

Income Effect

U2

Income and SubstitutionEffects: Inferior Good


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Chapter 4 Slide 34


A Special Case--The Giffen Good

The income effect may theoretically belarge enough to cause the demand

curve for a good to slope upward.

This rarely occurs and is of littlepractical interest.


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Chapter 4 Slide 35

Effect of a Gasoline Tax With a Rebate

Assume

Ped= -0.5

Income = $9,000 Price of gasoline = $1


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Chapter 4 Slide 36

Effect of a Gasoline Tax With a Rebate

Gasoline Consumption(gallons/year)

Expenditures

On OtherGoods ($)A

CGasoline = 1200 gallonsOther expenditures = $7800

U2

1200

Original BudgetLine

BD

U1

900

AfterGasoline

Tax

E

$.50 Excise TaxGasoline = 900 gallons

J

F

H

913.5

After Gasoline TaxPlus Rebate

U3

$450 REBATENew budget lineConsumer is worse off


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Chapter 4 Slide 37

Market Demand

Market Demand Curves

A curve that relates the quantity of agood that all consumers in a market buyto the price of that good.

From Individual to Market Demand

Determining the


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Chapter 4 Slide 38

Determining theMarket Demand Curve

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

Price Individual A Individual B Individual C Market($) (units) (units) (units) (units)

Summing to Obtain a


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Chapter 4 Slide 39

Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DB DC

Market Demand

DA

The market demandcurve is obtained by

summing the consumersdemand curves


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Chapter 4 Slide 40

Market Demand

Two Important Points

1) The market demand will shift to

the right as more consumersenter the market.

2) Factors that influence the

demands of many consumers willalso affect the market demand.


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Chapter 4 Slide 41

Market Demand

Elasticity of Demand

Recall: Price elasticity of demandmeasures the percentage change in the

quantity demanded resulting from a1-percent change in price.

PQPQ

P/PQ/QEP

//

Price Elasticity and


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Chapter 4 Slide 42

Price Elasticity andConsumer Expenditure

Demand If Price Increases, If Price Decreases,Expenditures: Expenditures:

Inelastic (Ep1) Decrease Increase


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Chapter 4 Slide 43

Market Demand

Point Elasticity of Demand

For large price changes (e.g. 20%), thevalue of elasticity will depend upon

where the price and quantity lie on thedemand curve.


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Chapter 4 Slide 44

Market Demand

Point Elasticity of Demand

Point elasticity measures elasticity at apoint on the demand curve.

Its formula is:

ope)(P/Q)(1/slE P


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Chapter 4 Slide 45

Market Demand

Problems Using Point Elasticity

We may need to calculate priceelasticity over portion of the demand

curve rather than at a single point.

The price and quantity used as the basewill alter the price elasticity of demand.


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Chapter 4 Slide 46

Market Demand

Assume

Price increases from 8$ to $10 quantitydemanded 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%

Point Elasticity of Demand (An Example)


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Chapter 4 Slide 47

Market Demand

Elasticity equals:

-33.33/.25 = -1.33 or -.50/.20 = -2.54 Which one is correct?

Point Elasticity of Demand (An Example)


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Chapter 4 Slide 48

Market Demand

Arc Elasticity of Demand

Arc elasticity calculates elasticity over arange of prices

Its formula is:

e quantitthe averagQ

e pricethe averagP

QPP)(Q/(E P

)/

M k D d


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Chapter 4 Slide 49

Market Demand

Arc Elasticity of Demand (An Example)

8.1)5/9)($2$/2(

52/10&92/184,6,10,8

)/

2121

pE

QPQQPP

QPP)(Q/(E P


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Chapter 4 Slide 50

The Aggregate Demand For Wheat

The demand for U.S. wheat is

comprised of domestic demand andexport demand.

An Example:


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Chapter 4 Slide 51


The domestic demand for wheat isgiven by the equation:

QDD=1700 - 107P

The export demand for wheat isgiven by the equation:

QDE=1544 - 176P


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Chapter 4 Slide 52


Domestic demand is relatively priceinelastic (-0.2), while export demandis more price elastic (-0.4).


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Chapter 4 Slide 53

C

D

ExportDemand

A

B

DomesticDemand

Total world demand isthe horizontal sum of thedomestic demand ABand

export demand CD.

F

Total Demand

E


Wheat(million bushels/yr.)

Price($/bushel)

0

2

46

8

10

1214

16

18

20

1000 2000 3000 4000

C S l


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Chapter 4 Slide 54

Consumer Surplus

Consumer Surplus

The difference between the maximumamount a consumer is willing to pay fora good and the amount actually paid.

C S l


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Chapter 4 Slide 55

The consumer surplusof purchasing 6 concerttickets is the sum of the

surplus derived fromeach one individually.

Consumer Surplus6 + 5 + 4 + 3 + 2 + 1 = 21

Consumer Surplus

Rock Concert Tickets

Price($ per

ticket)

2 3 4 5 6

13

0 1

14

15

1617

18

19

20

Market Price

C S l


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Chapter 4 Slide 56

Consumer Surplus

The stepladder demand curve can beconverted into a straight-line demandcurve by making the units of the good

smaller.

C S l


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Chapter 4 Slide 57

Demand Curve

ConsumerSurplus

ActualExpenditure

$19,50014)x6,5001/2x(20

Consumer Surplusfor the Market Demand

Consumer Surplus

Rock Concert Tickets

Price($ per

ticket)

2 3 4 5 6

13

0 1

14

15

1617

18

19

20

Market Price

C S l


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Chapter 4 Slide 58

Consumer Surplus

Combining consumer surplus withthe aggregate profits that producersobtain we can evaluate:

1) Costs and benefits of differentmarket structures

2) Public policies that alter thebehavior of consumers and firms

A E l


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Chapter 4 Slide 59

The Value of Clean AirAir is free in the sense that we dont

pay to breathe it. The Clean Air Act was amended in

1970.

Question: Were the benefits ofcleaning up the air worth the costs?

An Example:

The Val e of Clean Air


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Chapter 4 Slide 60

The Value of Clean Air

People pay more to buy houseswhere the air is clean.

Data for house prices amongneighborhoods of Boston and LosAngeles were compared with thevarious air pollutants.

Valuing Cleaner Air


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Chapter 4 Slide 61

The shaded area gives theconsumer surplus generated

when air pollution isreduced by 5 parts per 100million of nitrous oxide at

a cost of $1000 perpart reduced.

Valuing Cleaner Air

2000

100

1000

5

A

NOX (pphm)Pollution Reduction

Value($ per pphm

of reduction)



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Chapter 4 Slide 62


Up to this point we have assumedthat peoples demands for a goodare independent of one another.

If fact, a persons demand may beaffected by the number of otherpeople who have purchased thegood.



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Chapter 4 Slide 63


If this is the case, a networkexternality exists.

Network externalities can be positiveor negative.



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Chapter 4 Slide 64


A positive network externalityexists ifthe quantity of a good demanded bya consumer increases in response to

an increase in purchases by otherconsumers.

Negativenetwork externalities arejust the opposite.



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Chapter 4 Slide 65


The Bandwagon Effect

This is the desire to be in style, to havea good because almost everyone else

has it, or to indulge in a fad.

This is the major objective of marketingand advertising campaigns (e.g. toys,

clothing).

Positive Network


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Chapter 4 Slide 66

Externality: Bandwagon Effect

Quantity(thousands per month)

Price($ per

unit)

D20

20 40

When consumers believe morepeople have purchased theproduct, the demand curve shiftsfurther to the the right .

D40

60

D60

80

D80

100

D100

Positive Network


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Chapter 4 Slide 67

Demand



Price($ per

unit)

D20

20 40 60 80 100

D40 D60 D80 D100 The market demandcurve is found by joining

the points on the individualdemand curves. It is relatively

more elastic.

Positive Network


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Chapter 4 Slide 68

Demand



Price($ per

unit)

D20

20 40 60 80 100

D40 D60 D80 D100

Pure PriceEffect

48

Suppose the price fallsfrom $30 to $20. If there

were no bandwagon effect,quantity demanded would

only increase to 48,000

$20

$30

Positive Network


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Chapter 4 Slide 69

Demand



Price($ per

unit)

D20

20 40 60 80 100

D40 D60 D80 D100

Pure PriceEffect

$20

48

BandwagonEffect

But as more people buythe good, it becomesstylish to own it and

the quantity demandedincreases further.$30



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Chapter 4 Slide 70


The Snob Effect

If the network externality is negative, asnob effect exists.

The snob effect refers to the desire toown exclusive or unique goods.

The quantity demanded of a snobgood is higher the fewerthe peoplewho own it.

Negative Network


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Chapter 4 Slide 71

Externality: Snob Effect

Quantity (thousandsper month)

Price($ perunit) Demand

2

D2

$30,000

$15,000

14

Pure Price Effect

Originally demand is D2,when consumers think 2000

people have bought a good.

4 6 8

D4D6D8

However, if consumers think 4,000

people have bought the good,demand shifts from D2 to D6 and its

snob value has been reduced.

Negative NetworkS


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Chapter 4 Slide 72

Externality: Snob Effect

Quantity (thousandsper month)2 4 6 8

The demand is less elastic andas a snob good its value is greatly

reduced if more people ownit. Sales decrease as a result.

Examples: Rolex watches and longlines at the ski lift.

Price($ perunit)

D2

$30,000

$15,000

14

D4D6D8

Demand

Pure Price Effect

Snob EffectNet Effect

Network Externalities and the Demands


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Chapter 4 Slide 73

for Computers and Fax Machines

Examples of Positive FeedbackExternalities

Mainframe computers: 1954 - 1965

Microsoft Windows PC operatingsystem

Fax-machines and e-mail



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Chapter 4 Slide 74


The most direct way to obtaininformation about demand is throughinterviews where consumers are

asked how much of a product theywould be willing to buy at a givenprice.



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Chapter 4 Slide 75


Problem

Consumers may lack information orinterest, or be mislead by theinterviewer.



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Chapter 4 Slide 76

In direct marketing experiments,actual sales offers are posed topotential customers and the

responses of customers areobserved.




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Chapter 4 Slide 77

The Statistical Approach to DemandEstimation

Properly applied, the statistical

approach to demand estimation canenable one to sort out the effects ofvariables on the quantity demanded of aproduct.

Least-squares regression is oneapproach.


Demand Data for Raspberries


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Chapter 4 Slide 78

Year Quantity (Q) Price (P) Income(I)

Demand Data for Raspberries

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 201995 20 9 20

1996 22 5 20



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Chapter 4 Slide 79

Assuming only price determinesdemand:

Q = a - bP

Q =28.2-1.00P


Estimating Demand


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Chapter 4 Slide 80

Estimating Demand

Quantity

Price

0 5 10 15 20 25

15

10

5

25

20

d1

d2

d3

D

Drepresents demandif only Pdeterminesdemand and then fromthe data: Q=28.2-1.00P

Estimating Demand


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Chapter 4 Slide 81

Estimating Demand

Quantity

Price

0 5 10 15 20 25

15

10

5

25

20

D

d1

d2

d3

d1,d2,d3represent the demand for eachincome level. Including income in thedemand equation: Q = a - bP + cIorQ =8.08 - .49P+ .81I

Adjusting for changes in income



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Chapter 4 Slide 82

For the demand equation: Q = a - bP

Elasticity:


Estimating Elasticities

)/()/)(/( QPbQPPQEP



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Chapter 4 Slide 83

Assuming: Price & income elasticityare constant

The isoelastic demand =

The slope, -b= price elasticity of demand

Constant, c =income elasticity



)log()log()log( IcPbaQ



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Chapter 4 Slide 84

Using the Raspberry data:

Price elasticity = -0.24 (Inelastic)

Income elasticity = 1.46



)log(46.1)log(4.281.0)log( IPQ



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Chapter 4 Slide 85

Substitutes: b2is positive

Complements: b2is negative


Estimating Complements and Substitutes

)log(log)log()log( 22 IcPbPbaQ

The Demand for Ready-to-Eat Cereal


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Chapter 4 Slide 86

What Do You Think?

Are Grape Nuts & Spoon SizeShredded Wheat good substitutes?




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Chapter 4 Slide 87

Answer

Estimated demand for Grape Nuts (GN)

Price elasticity = -2.0

Income elasticity = 0.62Cross elasticity = 0.14


)log(014.)log(62.0)log(085.2998.1)log( SWGNGN PIPaQ

Summary


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Chapter 4 Slide 88

Summary

Individual consumers demandcurves for a commodity can bederived from information about their

tastes for all goods and services andfrom their budget constraints.

Engel curves describe therelationship between the quantity of agood consumed and income.

Summary


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Chapter 4 Slide 89

Summary

Two goods are substitutes if anincrease in the price of one goodleads to an increase in the quantity

demanded of the other. They arecomplements if the quantitydemanded of the other declines.

Summary


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Chapter 4 Slide 90

Summary

Two goods are substitutes if an increasein the price of one good leads to anincrease in the quantity demanded of theother. They are complements if thequantity demanded of the other declines.

The effect of a price change on thequantity demanded can be broken into asubstitution effect and an income effect.

Summary


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Chapter 4 Slide 91

Summary

The market demand curve is thehorizontal summation of theindividual demand curves for all

consumers.

The percent change in quantitydemanded that results from a onepercent change in price determineselasticity of demand.

Summary


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Chapter 4 Slide 92

Summary

There is a network externality whenone persons demand is affecteddirectly by the purchasing decisions

of other consumers.

A number of methods can be used toobtain information about consumerdemand.


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End of Chapter 4

Individual and

Market Demand

macroeconomy-pyndic-ch4

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