Individual and Market Demand - About …people.tamu.edu/~aglass/econ323/Chapter04Handout.pdfIncome...

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Chapter 4

Individual and Market Demand

Chapter Outline

©2015 McGraw‐Hill Education. All Rights Reserved.2

• Effects of Changes in Price and Income

• Income and Substitution Effects of a Price Change

• Consumer Response to Changes in Price

• Aggregating Individual Demand Curves into Market Demand

• Price and Cross‐price Elasticities of Demand

• The Dependence of Market Demand on Income• Appendix on Constant Elasticity of Demand

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The Effect of Changes in Price


• Price‐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).

Price‐Consumption Curve

• For Figure 4.1, suppose income M = $120, price of composite good Y is PY = $1/unit, and price of shelter varies as PS = $24, $12, $6, and $4/sq yd.

• The initial budget constraint isPYY PSS 24 120

120 24• Maximums (endpoints of budget constraint) are

120, 5


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• Initial tangency occurs at bundle S = 2.5 sq yd/wkand Y = $60/wk left for the composite.

• Reducing the price of shelter to $12 rotates the budget constraint out along the shelter axis.

12 120 120 1212012

10

• New tangency occurs at S’ = 7 and Y’ = $36/wk.



• Repeat these steps for additional price reductions.

– At PS = 6, consume S’’ = 15 and Y’’ = 30/wk.

– At PS = 4, consume S’’’ = 20 and Y’’’ = 40/wk.

• Connect the best affordable bundles (points of tangency) to construct the PCC.

– Exhibits common pattern of a dip then recovery.


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Figure 4.1: The Price‐Consumption Curve


Demand Schedule

Price of Shelter ($/sq yd) Quantity of Shelter Demanded (sq yd/wk)

24 2.5

12 7

6 15

4 20

• Construct by graphing the quantity of shelter demanded S (horizontal axis) versus the price of shelter PS (vertical axis) using PCC numbers, such as (S, PS) = (2.5, 24), (7, 12), (15, 6), (20, 4).


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Figure 4.2: An Individual Consumer’s Demand Curve


The Effects of Changes in Income


• Income‐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.

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Income‐Consumption Curve

• For Figure 4.3, suppose the price of shelter is PS = $10/sq yd, the price of the composite good is PY = $1, and income varies M = $40, $60, $100, $120.

• The initial budget constraint is10 40 40 10

• Maximums (endpoints of budget constraint) are

40, 4

• Initial tangency occurs at bundle S = 2 sq yd/wkand Y = $20/wk left for the composite.



• Increasing income to M’ = $60 shifts the budget constraint out parallel.

10 60 60 10

60, 6

• New tangency at bundle S’ = 3 and Y’ = $30/wk.

• Repeat to find S’’ = 5 and Y’’ = $50/wk when M’’ = $100 and S’’’ = 6 and Y’’’ = $60/wk when M’’’ = $120.


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• Connect the best affordable bundles (points of tangency) to form the ICC.

– It will have a positive slope if a normal good, where quantity demanded increases with income.


Income ($/wk) Quantity of shelter demanded (sq yd/wk)

40 2

60 3

100 5

120 6

Figure 4.3: An Income‐Consumption Curve


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Figure 4.4: An Individual Consumer’s Engel Curve


The Effects of Changes in Income


• 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 4.5: The Engel Curve for Normal and Inferior Goods


Total Effect of a Price Increase

• For Figure 4.6, suppose PY = $1, M = $120, the price of shelter is initially PS = $6/sq yd and then increases to $24/sq yd.

• Initial budget constraint and endpoints are6 120 120 6

120, 20

• Tangency at initial consumption bundle S = 10 sq yd/wk and Y = $60/wk (point A).


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Total Effect of a Price Increase

• When price of shelter increases to $24/sq yd, the new budget constraint and endpoints become

24 120 120 24

120, 5

• Tangency at new consumption bundle S’ = 2 sqyd/wk and Y’ = $72/wk (point D).

• The total effect on the quantity demanded of shelter is a reduction of 10 – 2 = 8 sq yd/wk.


Figure 4.6: The Total Effectof a Price Increase


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Income and Substitution Effects of a Price Change


• Substitution 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.

Income and Substitution Effects

• To break the total effect into separate income and substitution effects, need to draw a hypothetical budget constraint with the NEW relative price but tangent to the initial indifference curve.

24 240 240 24

240, 10

• If the price of shelter is $24, need $240 income so budget constraint tangent at point C with S’’ = 6 sq yd/wk and Y’’ = $96/wk.


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• The substitution effect is the move from point A to point C, a reduction in consumption of shelter of 10 – 6 = 4 sq yd/wk.

– As though income went up by enough to keep indifferent in face of a price increase so see only pure effect of changing relative prices.

• The income effect is the further move from point C to point D, a reduction in consumption of shelter of a further 6 ‐2 = 4 sq yd/wk.


Figure 4.7: The Substitution and Income Effects of a Price Change


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Price Increase Normal Good Inferior Good

Substitution Effect ‐ ‐

Income Effect ‐ +

Total Effect ‐ +/‐

• For an increase in price of a good, the substitution effect causes quantity demanded to fall.– The income effect causes quantity demanded to fall for

a normal good but rise for an inferior good.

– The total effect is a decrease in quantity demanded unless an inferior good and the income effect dominates substitution effect.


Figure 4.8: Income and Substitution Effects for an Inferior Good


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Giffen Goods


• Giffen good: one for which the quantity demanded rises as its price rises.

– The Giffen good must be an inferior good

– Income effect dominates substitution effect

Figure 4.9: The Demand Curvefor a Giffen Good


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IE & SE for Perfect Complements

• For Figure 4.10, suppose skis and bindings are perfect complements, consumed in a fixed one‐to‐one ratio. M = $1,200/yr and PB = PS = $200/pair.

• Initial budget constraint and endpoints200 200 1200 6

6, 6• Number of pairs of bindings must equal pairs of skis B = S due to being perfect complements. Solving 200S + 200S = 1200 gives B = S = 3 pairs.



• Now the price of bindings increases from $200 to $400, while everything else stays the same.

• New budget constraint and endpoints400 200 1200 6 2

3, 6

• Number of pairs of bindings must equal pairs of skis B = S due to being perfect complements. Solving 400S + 200S = 1200 gives B’ = S’ = 2 pairs.


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• To separate the total effect into separate income and substitution effects, we need to draw a pretend budget constraint with the higher price of bindings $400 and enough income to reach the initial indifference curve.

• If income rises to $1800, the budget constraint and endpoints would be

400 200 1800 6 2

4.5, 9• Number of pairs of bindings must equal pairs of skis B = S due to being perfect complements. Solving 400S + 200S = 1800 gives B’’ = S’’ = 3 pairs, the original choice.



• The substitution effect, the move from point A to point C due to higher price of bindings but with income compensated, is zero for perfect complements. – No ability to adjust mix of the two goods in response to changes in relative prices.

• The income effect, the move from point C to point D due to the higher price making bundles less affordable, is the full total effect, a reduction of one pair of bindings.


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Figure 4.10: Income and Substitution Effects for Perfect Complements


IE & SE for Perfect Substitutes

• For Figure 4.11, suppose tea and coffee are perfect substitutes in a one‐to‐one ratio (one cup of coffee is a good as one cup of tea). M = $12/wk, PC = $1/cup and PT = $1.20/cup.

• Initial budget constraint and endpoints

1.2 12 1056

12, .

10• Optimal bundle (point A) is 12 cups of coffee (and no tea), which is equivalent in satisfaction to 12 cups of tea (and no coffee).


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• Now suppose the price of coffee increases from $1 to $1.50/cup, while all else remains the same.

• New budget constraint and endpoints1.5 1.2 12 10 1.25

.8,

.10

• Optimal bundle (point D) is 10 cups of tea (with no coffee), which is equivalent in satisfaction to 10 cups of coffee (with no tea).



• Construct budget constraint with the higher price of coffee and enough income to reach initial indifference curve.

• New budget constraint and endpoints1.5 1.2 14.4 12 1.25

.

.9.6, .

.12

• Need an additional $2.40 to afford two more cups of tea so point C is 12 cups of tea (with no coffee), which is equivalent in satisfaction to the original 12 cups of coffee (with no tea).


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• Substitution effect is a dramatic reduction in coffee consumption of 12 – 0 = 12 cups, the total effect.

• Substitution effects for perfect substitutes can be very large if they induce a switch from one good to the other.


Figure 4.11: Income and Substitution Effects for Perfect Substitutes


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Demand for Car Washes

• For Figure 4.14, M = $144, PG = $3/gal. Buy 1 car wash for every 10 gallons of gas (G = 10C). Consider prices of car washes such as $6, $18 and $42 to construct individual demand curve.

3 6 144 48 2

48, 24

3(10C) + 6C = 144, 36C = 144, C = 4, G = 40/wk


Demand for Car Washes

• When car washes cost $183 18 144 48 6

48, 8

3(10C) + 18C = 144, 48C = 144, C = 3, G = 30/wk

• When car washes cost $423 42 144 48 14

48, 3.43

3(10C) + 42C = 144, 72C = 144, C = 2, G = 20/wk


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Figure 4.14: A Price Increasefor Car Washes


Figure 4.15: James’ Demandfor Car Washes


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Market Demand Curves


• Market demand curve: the horizontal summation of the individual demand curves.

• .

Figure 4.16: Generating Market Demand from Individual Demands


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Figure 4.17: The Market Demand Curve for Beech Saplings


Market Demand with Identical Consumers

• For Figure 4.18, suppose have 10 identical consumers, each with individual demand P = 10 – 5Qi or Qi = 2 – P/5.

• Market demand

10 10 2 20 2P

20 2 1012


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Market Demand with Identical Consumers

• In general, for a market with n identical individual demand P = a – bQi, the market demand will be


Figure 4.18: Market Demand with Identical Consumers


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Price Elasticity of Demand

• Price elasticity of demand: the percentage change in the quantity of a good demanded that results from a 1 present change in its price.

ЄΔQ/QΔ /

ΔΔP

1


Three Categories of Price Elasticity


• Inelastic → |Є| < 1

• Elastic → |Є| > 1

• Unit elastic → |Є| = 1

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Figure 4.19: Three Categoriesof Price Elasticity


Figure 4.20: The Point‐Slope Method


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Figure 4.21: Two Important Polar Cases


Elasticity and Total Revenue


• 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.

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


Figure 4.24: Demand and Total Expenditure


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Demand for Bus Rides

• For Figure 4.25, P = 100 – Q/10. If P = 50 cents/ride (point M), how much revenue will be collected?

50 10010

500

$0.50 500 $250• What is the price elasticity of demand?

ЄΔQ/QΔ /

ΔΔP

1 50500

101

1

• Should the system raise or lower prices to increase revenue? Neither, revenue is maximized (unit elasticity).


Demand for Bus Rides

• For P’ = 75 cents/ride (point K), how much revenue will be collected?

75 10010

250

$0.75 250 $187.50• What is the price elasticity of demand?

Є1 75

250101

3

• Should the system raise or lower prices to increase revenue? Lower prices (demand is elastic).


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Figure 4.25: Demand for Bus Rides


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 4.26: Price Elasticity Is Greater in the Long Run than in the Short Run


Figure 4.27: The Engel Curve for Foodof A and B


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Figure 4.28: Market Demand Sometimes Depends on the Distribution of Income


Figure 4.29: An Engel Curveat the Market Level


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Income Elasticity of Demand

• If a good exhibits a stable Engle curve, we can define its income elasticity of demand, the percentage change in the quantity of a good demanded that results from a 1 percent change in income.



Figure 4.30: Engel Curves for Different Types of Goods

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Cross‐Price Elasticities of Demand

• Cross‐price elasticity of demand: the percentage change in the quantity of one good demanded that results from a 1 percent change in the price of the other good.


Problem 1

1. Sam spends $6/wk on orange juice and apple juice. Orange juice costs $2/cup while apple juice costs $1/cup. Sam views 1 cup of orange juice as a perfect substitute for 3 cups of apple juice. Find Sam’s optimal consumption bundle of orange juice and apple juice each week. Suppose the price of apple juice rises to $2/cup, while the price of orange juice remains constant. How much additional income would Sam need to afford his original consumption bundle?


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Solution 1

• Budget constraint and endpoints2 6 6 2

3, 6

• Optimal consumption bundle is 3 cups of orange juice (and no apple juice), which viewed as good as 9 cups of apple juice (and no orange juice).

• If the price of apple juice doubles from $1 to $2/cup, Sam would not need any additional income as he was not consuming any apple juice.


Solution 1 Figure

0

3

6

9

0 3

Apple Juice (cups)

Orange Juice (cups)

B0

B1

I0


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Problem 2

2. Maureen has the same income and faces the same prices as Sam, but Maureen views 1 cup of orange juice and 1 cup of apple juice as perfect complements. Find Maureen’s optimal consumption bundle. How much additional income would Maureen need to afford her original consumption bundle when the price of apple juice doubles?


Solution 2

• Substitute OJ = AJ into budget constraint

2 6 2 6 2

• Optimal consumption bundle is 2 cups of apple juice and 2 cups of orange juice per week.

• If the price of apple juice doubles from $1 to $2/cup, Maureen would need $2 more income ($1 more for each of two cups of apple juice).


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Solution 2 Figure

0

1

2

3

4

5

6

0 1 2 3 4

Apple Juice (cups)

Orange Juice (cups)

B0

B1

I0AJ=OJ

B2


Problem 3

3. Suppose the demand for crossing the Golden Gate Bridge is given by Q = 10,000 ‐ 1000P.

a. If the toll (P) is $2, how much revenue is collected?

b. What is the price elasticity of demand at this point?

c. Could the bridge authorities increase their revenues by changing their price?

d. The Red and White Lines, a ferry service that competes with the Golden Gate Bridge, began operating hovercrafts that made commuting by ferry much more convenient. How would this affect the elasticity of demand for trips across the Golden Gate Bridge?


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Solution 3

• How much revenue will be collected? 10000 1000 10,000 2,000 8,000

$2 8,000 $16,000• What is the price elasticity of demand?

ЄΔQ/QΔ /

1 28000

10001

14

• Raise prices to increase revenue (demand inelastic). Increased competition from ferries would make demand more price elastic.


Solution 3 Figure

0

2

4

6

8

10

0 2000 4000 6000 8000 10000

Price

Quantity

e = ‐1/4

1

‐1/1000


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Problem 4

4. Professors Adams and Brown make up the entire demand side of the market for summer research assistants in the economics department. If Adam’s demand curve is P = 50 ‐2QA and Brown’s is P = 50 ‐ QB, where QA and QB

are the hours demanded by Adams and Brown, respectively, what is the market demand for research hours in the economics department?


Solution 4

• Professor Adam (price intercept 50, Q intercept 25)

50 2 2512

• Professor Brown (price intercept 50, Q intercept 50)50 50

• Market demand (price intercept 50, Q intercept 75)

2512

50

7532

5023


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Solution 4 Figure

0

50

0 25 50 75

D

DA


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