Individual and Market Demand Lecture Outline

Microeconomics

Claudia Vogel

EUV

Winter Term 2009/2010

Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 1 / 32

Individual and Market Demand

Lecture Outline

Part II Producers, Consumers, and Competitive Markets

4 Individual and Market DemandIndividual DemandIncome and Substitution E�ectsMarket DemandConsumer SurplusNetwork ExternalitiesSummary


Individual and Market Demand Individual Demand

Individual Demand Curve

price-consumption curve: Curvetracing the utility-maximizingcombinations of two goods as theprice of one changes.

individual demand curve: Curverelating the quantity of a good thata single consumer will buy to itsprice.



Income changes

income-consumption curve:Curve tracing the utility-maximizingcombinations of two goods as theincome of the consumer changes.



Normal versus Inferior Goods



Engel Curves

Engel curve: Curve relating the quantity of a good consumed to income.



Example: Consumer Expenditures in the United States



Substitutes and Complements

Recall that:

Two goods are substitutes if an increase in the price of one leads to anincrease in the quantity demanded of the other.

Two goods are complements if an increase in the price of one good leads to adecrease in the quantity demanded of the other.

Two goods are independent if a change in the price of one good has no e�ecton the quantity demanded of the other.


Individual and Market Demand Income and Substitution E�ects

E�ects of Price Changes

A fall in the price of a good has two e�ects:

1 Consumers will tend to buy more of the good that has become cheaper andless of those that are now relatively more expensive.

2 Because one of the goods is now cheaper, consumers enjoy an increase in realpurchsing power.



Income and Substitution E�ects: Normal Goods

substitution e�ect: Change inconsumption of a good associatedwith a change in its price, with thelevel of utility held constant.

income e�ect: Changes inconsumption of a good resultingfrom an increase in purchasingpower, with relative prices heldconstant.

The total e�ect of a change in price is given theoretically by the sum of thesubstitution e�ect and the income e�ect:

Total E�ect (F1F2)= Substitution E�ect (F1E ) + Income E�ect (EF2)



Income and Substitution E�ects: Inferior Goods



A Special Case: The Gi�en Good

Gi�en Good: Good whose demand curve slopes upward because the(negative) income e�ect is larger than the substitution e�ect.



Example: The E�ects of a Gasoline Tax


Individual and Market Demand Market Demand

From Individual to Market Demand 1/3

market demand curve: Curve relating the quantity of a good that allconsumers in a market will buy to its price.

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

1 6 10 16 322 4 8 13 253 2 6 10 184 0 4 7 115 0 2 4 6







Two points should be noted as a result of this analysis:

1 The market demand curve will shift to the right as more consumers enter themarket.

2 Factors that in�uence the demands of many consumers will also a�ect marketdemand.

The aggregation of individual demands into market demands becomes importantin practice when market demands are built up from the demands of di�erentdemographic groups or from consumers located in di�erent areas.



Elasticity of Demand 1/2

Denoting the quantity of a good by Q and its price P, the price elasticity ofdemand is

EP =4Q/Q

4P/P=

(P

Q

)(4Q

4P

)

Inelastic Demand: When Demand is inelastic (i.e. EP is less than 1 in absolutevalue), the quantity demanded is relatively unresponsive to changes in price. As aresult, total expenditure on the product increases when the price increases.

Elastic Demand: When demand is elastic (i.e. EP is greater than 1 in absolutevalue), the total expenditure on the product decreases as the price goes up.



Elasticity of Demand 2/2

Isoelastic demand curve: Demand curve with a constant price elasticity.

Demand If Price Increases, If Price DecreasesExpenditures Expenditures

Inelastic increase decreaseUnit elastic are unchanged are unchangedElastic decrease increase



Example: The Aggregate Demand for Wheat

Domestic Demand: QDD = 1430− 55P

Export Demand: QDE = 1470− 70P

World Demand: QD = (1430− 55P) + (1470− 70P) = 2900− 125P



Example: The Demand for Housing

Price and Income Elasticity of the Demand for Rooms

Group Price Elasticity Income ElasticitySingle Individuals -0.10 0.21Married, head of household, -0.25 0.06age less than 30, 1 childMarried, head of household, age 30-39 -0.15 0.122 or more childrenMarried, head of household, -0.08 0.19age 50 or older, 1 child


Individual and Market Demand Consumer Surplus

Consumer Surplus and Demand

consumer surplus: Di�erence between what a consumer is willing to pay fora good and the amount actually paid.


Individual and Market Demand Consumer Surplus

Applying Consumer Surplus

When added over many individuals, it measures the aggregate bene�t thatconsumers obtain from buying goods in a market.

When we combine consumer surplus with the aggregate pro�ts that producersobtain, we can evaluate both the costs and the bene�ts not only of alternativemarklet structures, but of public policies that alter the behavior of consumers and�rms in those markets.


Individual and Market Demand Network Externalities

Network Externalities

network externality: Situation in which each individual's demand dependson the purchases of other individuals

A positive network externality exists if the quantity of a good demanded by atypical consumer increases in response to the growth in purchases of otherconsumers. If the quantity demanded decreases, there is a negative network

externality.

Bandwagon E�ect: Positive network externality in which a consumer wishesto possess a good in part because others do.

Snob E�ect: Negative network externality in which a consumer wishes toown an exclusive or unique good.


Individual and Market Demand Network Externalities

Bandwagon and Snob E�ect


Individual and Market Demand Summary

Summary 1/3

Individual consumers' demand curves for a commodity can be derived frominformation about their tastes for all goods and services and from theirbudget constraints.

Engel curves, which describe the relationship between the quantity of a goodconsumed and income, can be useful for discussions of how consumerexpenditures vary with income.

Two goods are substitutes if an increase in the price of one leads to anincrease in the quantity demanded of the other. In contrast, two goods arecomplements if an increase in the price of one leads to a decrease in thequantity demanded of the other.



Summary 2/3

The e�ect of a price change on the quantity demanded of a good can bebroken into two parts: a substitution e�ect, in which satisfaction remainsconstant while price changes, and an income e�ect, in which the priceremains constant while satisfaction changes. Because the income e�ect canbe either positive or negative, a price change can have a small or a largee�ect on quantity demanded. In the unusual case of a so-called Gi�en good,the quantity demanded may move in the same direction as the price change,thereby generating an upward-sloping individual demand curve.

The market demand curve is the horizontal summation of the individualdemand curves of all consumers in the market for a good. It can be used tocalculate how much people value the consumption of particular goods andservices.



Summary 3/3

Demand is price inelastic when a 1-percent increase in price leads to a lessthen 1-percent decrease in quantity demanded, thereby increasing theconumser's expenditure. Demand is price elastic when a 1-percent increase inprice leads to a more than 1-percent decrease in quantity demanded, therebydecreasing the consumer's expenditure. Demand is unit elastic when a1-percent increase in price leads to a 1-percent decrease in quantitydemanded.

The concept of consumer surplus can be useful in determining the bene�tsthat people receive from the consumption of a product. Consumer surplus isthe di�erence between the maximum amount a consumer is willing to pay fora good and what he actually pays when buying it.

A network externality occurs when a person's demand is a�ected directly bythe purchasing decisions of other consumers. A positive network externality,the bandwagon e�ect, occurs when a typical consumer's quantity demandedincreases because she considers it stylish to buy a product that others havepurchased. Conversely, a negative network externality, the snob e�ect, occurswhen the quantity demanded increases when fewer people own the good.


Exercises 3

Problem 1

Explain the di�erence between each of the following terms:

1 a price consumption curve and a demand curve

2 an individual demand curve and a market curve

3 an Engel curve and a demand curve

4 an income e�ect and a substitution e�ect


Exercises 3

Problem 2

Suppose that a consumer spends a �xed amount of income per month on thefollowing pairs of goods:

1 tortilla chips and salsa

2 tortilla chips and potatoe chips

3 movie tickets and gourmet co�ee

4 travel by bus and travel by subway

If the price of one of the goods increases, explain the e�ect on the quantitydemanded of each of the goods. In each pair, which are likely to be complementsand which are likely to be substitutes?


Exercises 3

Problem 3

For which of the following goods is a price increase likely to lead to a substantialincome (as well as substitution) e�ect?

1 salt

2 housing

3 theater tickets

4 food


Exercises 3

Problem 4

The director of a theater company in a small college town is considering changingthe way he prices tickets. He has hired an economic consulting �rm to estimatethe demand for tickets. The �rm has classi�ed people who go to the theater intotwo groups, and has come up with two demand functions. The demand curves forthe general public (Qgp) and students(Qs) are given below:

Qgp = 500− 5P Qs = 200− 4P

1 Graph the two demand curves on one graph, with P on the vertical axis andQ on the horizontal axis. If the current price of tickets is $35, identify thequantity demanded by each group.

2 Find the price elasticity of demand for each group at the current price andquantity.

3 Is the director maximizing the revenue he collects from ticket sales bycharging $35 for each ticket? Explain.

4 What price should he charge each group if he wants to maximize revenuecollected from ticket sales?


Exercises 3

Problem 5

By observing an individual's behavior in the situations outlined below, determinethe relevant income elasticities of demand for each good (i.e. whether the good isnormal or inferior). If you cannot determine the income elasticity, what additionalinformation do you need?

1 Bill spends all his income on books and co�ee. He �nds $20 whilerummaging through a used paperback bin at the bookstore. He immedeatelybuys a new hardcover book of poetry.

2 Bill loses $10 he was going to buy a doule espresso. He decides to sell hisnew book at a discount to a friend and use the money to buy co�ee.

3 Co�ee and book prices rise by 25 percent. Bill lowers his consumption ofboth goods by the same percentage.

4 Bill drops out of art school and gets an M.B.A. instead. He stops readingbooks and drinking co�ee. Now he reads The Wall Street Journal and drinksbottled mineral water.


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Individual and Market Demand Lecture Outline

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