INDIVIDUAL AND MARKET DEMAND

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Chapter 4

*Focus is on how purchase decisions respond to variations in price and income.*Recall the Budget Constraint: PS *S + PF * F = M: slope = - PF/PS

*The IC analysis in Chapter 3 is employed in analyzing consumer respond to price and income changes.

Chapter Outline

The Effects of Changes in the Price The Effects of Changes in Income The Income and Substitution Effects of a Price Change Consumer Responsiveness to Changes in Price Market Demand: Aggregating Individual Demand Curves Price Elasticity of Demand The Dependence of Market Demand on Income Application: Forecasting Economic Trends Cross-price Elasticities of Demand

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Figure 4.1: The Price-Consumption Curve

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The Effect of Changes in PricePrice-consumption curve (PCC): for a good X is the set of optimal bundles traced on an indifference map as the price of X varies (holding income and the price of Y constant). Note: as one moves along a demand curve, the real standard of living changes

Goods = X and Y

An Individual Consumer’s Demand Curve

Figure 4.3: An Income-Consumption Curve

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The Effects of Changes in IncomeIncome-consumption curve (ICC): for a good X is the set of optimal bundles traced on an indifference map as income varies (holding the prices of X and Y constant).Engel curve: curve that plots the relationship between the quantity of X consumed and income.Note: As income increases, the consumption of Shelter increases, ceteris paribus. Hence, Shelter is a normal good.

Normal good: one whose quantity demanded rises as income rises.

Inferior good: one whose quantity demanded falls as income rises.

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Figure 4.4: An Individual Consumer’s Engel Curve

Figure 4.5: The Engel Curve for Normal and Inferior Goods

Engel Curves – relates income to the consumption of a good.

Engel Curve – curve that plots the relationship between the quantity of X (=shelter in this case) consumed and income, ceteris paribus on (a) tastes/preferences and relative prices.Note: similar to the ICC curve. Differences lie on the verticals: the ICC – measures consumer expenditure but Engel Curve –consumer’s income

Figure 4.6: The Total Effect of a Price Increase

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Income and Substitution EffectsSubstitution effect: that component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods.

Income effect: that component of the total effect of a price change that results from the associated change in real purchasing power.

Total effect: the sum of the substitution and income effects.

The Slutsky Equation = |X X XXU

X X

Overall Q Q QQ

Given P P Income

The Income Effect can be easily weighted against the negative Substitution Effect to see if a Giffen or Inferior good is present. The 1st RHS term is the Substitution Effect (always negative) but the 2nd term is the Income Effect which can be positive (for a normal good) or negative (for an inferior good).

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Figure 4.8: Income and Substitution Effects for an Inferior Good

Figure 4.7: The Substitution and Income Effects of a Price Sensitive Good A->C: 8-12=-4=

reduction of Substitution Effect (negative)C->D: 9-8= +1-> Income Effect (positive)Overall Effect/Total Effect = -4+1 = -3:Price increases ≈ income decrease

A->C: Substitution Effect -> 6-10 =-4C->D: Income Effect ->-2-6=-4Total Effect = -4+-4 = -8

Figure 4.13: Income and Substitution Effects for a Price-Sensitive Good

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Substitution Effect: 55-100 =-45Income Effect : 20-55 = -35Total Effect = -35+ -45 = -80

Figure 4.16: Generating Market Demand from Individual

Demands

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Market Demand CurvesMarket demand curve: the horizontal summation of the individual demand curves. Note: it requires that demands be stated as Q =f(p) not P=f(Q). The latter is standard and we have Alfred Marshall to blame. Horizontal addition makes sense with the former but it is difficult to change convention!

Price elasticity of demand: the present percentage change in the quantity of a good demanded that result from a 1 present change in its price, ceteris paribus

Three Categories of Price Elasticity

1.Elastic → € < -1 2. Inelastic → € > -1 3. Unit elastic → € = 1Elasticity is important see most consumers tend to see the world in terms of proportions rather than absolute values. Check

yourself against the following behavior.1.Why will you drive across town to get a shirt for $10 off the regular price but choose to stay with your regular car dealer if the car costs $10 more?2.Why would there be rejoicing in the hall if the price of Coke fell 25 cents in the dorm machine, but scoffing if the tuition bill dropped 25 cents?3.Why can we tell the difference between a 10-and 25-watt bulb, but have trouble distinguishing between a 200-and a 185-watt bulb?Note: Price Elasticity (€) is a property of the good or service in question.

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Diagnostic Quiz

Price

Quantity

D3

D2

D1

BC

A

Problem: Most people think that price elasticity is related only to the slope of the demand function.

Quiz1.Demand D1 is less elastic at point B than is demand D2-----2.Demand D2 has the same elasticity at B that demand D3 has at point C3.Demand curve D1 has the same elasticity at A and B4.Point A of Demand D1 is definitely less elastic than point C on Demand D35.Point C on Demand D3 is elastic.Idea: Both the slope and location are important in determining price elasticity!

Method I: The Point-Slope Method

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1*( )A

AA

P

Q Slope or at A,

Figure 4.21: Two Important Polar Cases

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The denominator (% change in P) changes but the numerator does!

The denominator (% change in Q)doesn’t change but the numerator does!

Price Elasticity and the Total Revenue Relationship

A price reduction will increase total revenue if and only if the absolute value of the price elasticity of demand is greater than 1.

An increase in price will increase total revenue if and only if the absolute value of the price elasticity is less than 1.

An increase in price (around a fat point) will leave total revenue unchanged if the absolute value of price elasticity is unity.

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Figure 4.23: The Effect on Total Expenditure of a Reduction in Price

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∆TR = ∆PQ + P∆Q + ∆P∆Q0

(E)

(G)

Figure 4.24: Demand and Total Expenditure

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Determinants of Price Elasticity of Demand

Substitution possibilities: the substitution effect of a price change tends to be small for goods with no close substitutes.

Budget share: the larger the share of total expenditures accounted for by the product, the more important will be the income effect of a price change.

Direction of income effect: a normal good will have a higher price elasticity than an inferior good.

Time: demand for a good will be more responsive to price in the long-run than in the short-run.

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Figure A4.2: The Segment-Ratio Method

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Suppose EC = 1.8, AC =0.88. Thus εC= 1.8/0.88 = 2.05 > 1: Elastic