CHAPTER 4Individual and market demand

OutcomesDerive individual demand curveEffect of change in price and income on the

demand curveMarket demand curveConsumer surplusEffects of network externalities

CHANGES IN EQUILIBRIUMHow does the equilibrium position change if:

1. Consumer’s income changeOR

2. Price of one of the goods change

Income Effect on Consumer Equilibrium Change in income, all prices remaining constant.

If prices of goods, tastes and preferences of the consumer remain constant and there is a change in income, it will directly affect consumer’s equilibrium.

A rise in the income of a consumer shifts the Budget line to the right upward on higher IC.

A fall in the income shifts the Budget line to the left side on lower IC.

Income Effect on Consumer Equilibrium A rise in the Income: Consumer can buy

more of both commodities = Higher level of satisfaction and increase in equilibrium.

A fall in the Income = Consumer buy less of both the commodities = Lower level of satisfaction and decrease in equilibrium.

The line which touches all the consumer equilibrium points = Income Consumption Curve (ICC).

ICC = The consumption of two goods is affected by change in income when prices are constant.

Income Effect on Consumer

Equilibrium

Price Effect on Consumer Equilibrium Price Effect = A result of change in the price of

one commodity while price of other good and income of the consumer remain constant.

The change in demand in response to a change in price of a commodity, other things remaining the same (Ceteris Paribus), is called Price effect.

If we draw a line which touches all the consumer equilibrium points so we will get Price Consumption Curve (PCC).

PCC = The consumption of good X changes, as its price changes, remaining constant the price of good Y and the income of the consumer.

Price Effect on Consumer Equilibrium

NORMAL AND INFERIOR GOODSNormal goods = Willing and able to buy

anything with an income increases or the price decreases Example: NEW clothing, NEW car, NEW computer.

Inferior goods = Comparable to the normal good. More willing to purchase as income decreases or the price increases Example: USED clothing, USED car, USED computer i.e. income and quantity.

Effect on an inferior good

Engel CurvesCurve relating the quantity of a good

consumed to income.

Income and substitution effects Price:

Consumer will buy more of cheaper good and less of relatively more expensive good.

One good cheaper Consumer enjoy increase in real purchasing power.

Two effects occur simultaneously

Income and substitution effects: Normal Good

Substitution effectChange in consumption of a good with a

change in its price, with the level of utility held constant.

Income effectChange in consumption of a good resulting from

an increase in purchasing power, with relative prices held constant.

Total effectTotal Effect (F1F2) = Substitution effect

(F1E) + Income Effect (EF2)

Income and substitution effects: Inferior Goods

Special Case: GIFFEN GOODSTheoretically

possible (but doubted): Good whose

demand curve slopes upward because the negative income effect is larger than the substitution effect.

Market demand curveDiscussed in Chapter 2

ELASTICITY: RecapInelastic demand: Quantity demanded is

relatively unresponsive to changes in price, e.g.. Gasoline

Elastic demand: Expenditure on the product decreases as the price goes up, e.g.. Beef

Isoelastic demand: Demand curve with constant price elasticity.Special isoelastic demand curve: unit-elastic

demand curve -1.

Consumer SurplusDefinition: Difference between

Willing to pay for a good, and;Amount actually paid

Calculate from the demand curve

Network externalitiesAssumption: Demand for a good are

independent of one another.However, for some goods demand depends on

the demand of other people.Network externalities exist.

Definition: Situation in which each individual’s demand,depends on the purchases of other individuals

Positive or negativePositive = Quantity of good demand by

consumer increase in response to the growth in purchases of other consumers.

Negative = Vice versa, demand decreases

Network externalities- The bandwagon effectPositive network externalityDefinition: Consumer wishes to possess a

good in part because others do, e.g.. Toys: Playstation, Xbox

Exploited by marketers

Network externalities- Snob effectNegative externality.Definition:

Consumer wishes to own an exclusive or unique good e.g.. Works of art, sports car

Prestige, status and exclusivity