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 Demand
Individual Demand
Income and Substitution Eects
Market Demand
Consumer Surplus
Network Externalities
Summary
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Individual and Market Demand
Individual Demand
Individual Demand Curve
price-consumption curve: Curve
tracing the utility-maximizing
combinations of two goods as the
price of one changes.
individual demand curve: Curve
relating the quantity of a good that
a single consumer will buy to its
price.
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Microeconomics
Individual and Market Demand
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Individual Demand
Income changes
income-consumption curve:
Curve tracing the utility-maximizing
combinations of two goods as the
income of the consumer changes.
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Individual and Market Demand
Individual Demand
Normal versus Inferior Goods
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Individual and Market Demand
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Individual Demand
Engel Curves
Engel curve: Curve relating the quantity of a good consumed to income.
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Individual and Market Demand
Individual Demand
Example: Consumer Expenditures in the United States
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Individual Demand
Substitutes and Complements
Recall that:
Two goods are substitutes if an increase in the price of one leads to an
increase in the quantity demanded of the other.
Two goods are complements if an increase in the price of one good leads to a
decrease in the quantity demanded of the other.
Two goods are independent if a change in the price of one good has no eect
on the quantity demanded of the other.
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Microeconomics
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Individual and Market Demand
Income and Substitution Eects
Eects of Price Changes
A fall in the price of a good has two eects:
1
Consumers will tend to buy more of the good that has become cheaper and
less of those that are now relatively more expensive.
2
Because one of the goods is now cheaper, consumers enjoy an increase in real
purchsing power.
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Microeconomics
Individual and Market Demand
Winter Term 2009/2010
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Income and Substitution Eects
Income and Substitution Eects: Normal Goods
substitution eect: Change in
consumption of a good associated
with a change in its price, with the
level of utility held constant.
income eect: Changes in
consumption of a good resulting
from an increase in purchasing
power, with relative prices held
constant.
The total eect of a change in price is given theoretically by the sum of the
substitution eect and the income eect:
Total Eect (F1 F2 )= Substitution Eect (F1 E ) + Income Eect (EF2 )
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Individual and Market Demand
Income and Substitution Eects
Income and Substitution Eects: Inferior Goods
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Income and Substitution Eects
A Special Case: The Gien Good
Gien Good: Good whose demand curve slopes upward because the
(negative) income eect is larger than the substitution eect.
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Individual and Market Demand
Income and Substitution Eects
Example: The Eects of a Gasoline Tax
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Market Demand
From Individual to Market Demand 1/3
market demand curve: Curve relating the quantity of a good that all
consumers in a market will buy to its price.
Price ($) Individual A Individual B Individual C Market
(Units)
(Units)
(Units)
(Units)
1
2
3
4
5
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6
4
2
0
0
10
8
6
4
2
Microeconomics
16
13
10
7
4
32
25
18
11
6
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Individual and Market Demand
Market Demand
From Individual to Market Demand 2/3
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Individual and Market Demand
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Market Demand
From Individual to Market Demand 3/3
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 the
market.
2
Factors that inuence the demands of many consumers will also aect market
demand.
The aggregation of individual demands into market demands becomes important
in practice when market demands are built up from the demands of dierent
demographic groups or from consumers located in dierent areas.
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Microeconomics
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Individual and Market Demand
Market Demand
Elasticity of Demand 1/2
Denoting the quantity of a good by Q and its price P, the price elasticity of
demand is
4Q /Q
EP =
=
4P /P
P
Q
4Q
4P
Inelastic Demand: When Demand is inelastic (i.e. EP is less than 1 in absolute
value), the quantity demanded is relatively unresponsive to changes in price. As a
result, total expenditure on the product increases when the price increases.
Elastic Demand: When demand is elastic (i.e. EP is greater than 1 in absolute
value), the total expenditure on the product decreases as the price goes up.
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Individual and Market Demand
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Market Demand
Elasticity of Demand 2/2
Isoelastic demand curve: Demand curve with a constant price elasticity.
Demand
Inelastic
Unit elastic
Elastic
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If Price Increases, If Price Decreases
Expenditures
Expenditures
increase
are unchanged
decrease
Microeconomics
decrease
are unchanged
increase
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Individual and Market Demand
Market Demand
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
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Individual and Market Demand
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Market Demand
Example: The Demand for Housing
Group
Price and Income Elasticity of the Demand for Rooms
Price Elasticity Income Elasticity
Single Individuals
Married, head of household,
age less than 30, 1 child
Married, head of household, age 30-39
2 or more children
Married, head of household,
age 50 or older, 1 child
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-0.10
-0.25
0.21
0.06
-0.15
0.12
-0.08
0.19
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Individual and Market Demand
Consumer Surplus
Consumer Surplus and Demand
consumer surplus: Dierence between what a consumer is willing to pay for
a good and the amount actually paid.
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Consumer Surplus
Applying Consumer Surplus
When added over many individuals, it measures the aggregate benet that
consumers obtain from buying goods in a market.
When we combine consumer surplus with the aggregate prots that producers
obtain, we can evaluate both the costs and the benets not only of alternative
marklet structures, but of public policies that alter the behavior of consumers and
rms in those markets.
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Microeconomics
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Individual and Market Demand
Network Externalities
Network Externalities
network externality: Situation in which each individual's demand depends
on the purchases of other individuals
A positive network externality exists if the quantity of a good demanded by a
typical consumer increases in response to the growth in purchases of other
consumers. If the quantity demanded decreases, there is a negative network
externality.
Bandwagon Eect: Positive network externality in which a consumer wishes
to possess a good in part because others do.
Snob Eect: Negative network externality in which a consumer wishes to
own an exclusive or unique good.
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Individual and Market Demand
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Winter Term 2009/2010
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Network Externalities
Bandwagon and Snob Eect
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Microeconomics
Individual and Market Demand
Summary
Summary 1/3
Individual consumers' demand curves for a commodity can be derived from
information about their tastes for all goods and services and from their
budget constraints.
Engel curves, which describe the relationship between the quantity of a good
consumed and income, can be useful for discussions of how consumer
expenditures vary with income.
Two goods are substitutes if an increase in the price of one leads to an
increase in the quantity demanded of the other. In contrast, two goods are
complements if an increase in the price of one leads to a decrease in the
quantity demanded of the other.
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Microeconomics
Individual and Market Demand
Winter Term 2009/2010
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Summary
Summary 2/3
The eect of a price change on the quantity demanded of a good can be
broken into two parts: a substitution eect, in which satisfaction remains
constant while price changes, and an income eect, in which the price
remains constant while satisfaction changes. Because the income eect can
be either positive or negative, a price change can have a small or a large
eect on quantity demanded. In the unusual case of a so-called Gien 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 individual
demand curves of all consumers in the market for a good. It can be used to
calculate how much people value the consumption of particular goods and
services.
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Microeconomics
Winter Term 2009/2010
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Individual and Market Demand
Summary
Summary 3/3
Demand is price inelastic when a 1-percent increase in price leads to a less
then 1-percent decrease in quantity demanded, thereby increasing the
conumser's expenditure. Demand is price elastic when a 1-percent increase in
price leads to a more than 1-percent decrease in quantity demanded, thereby
decreasing the consumer's expenditure. Demand is unit elastic when a
1-percent increase in price leads to a 1-percent decrease in quantity
demanded.
The concept of consumer surplus can be useful in determining the benets
that people receive from the consumption of a product. Consumer surplus is
the dierence between the maximum amount a consumer is willing to pay for
a good and what he actually pays when buying it.
A network externality occurs when a person's demand is aected directly by
the purchasing decisions of other consumers. A positive network externality,
the bandwagon eect, occurs when a typical consumer's quantity demanded
increases because she considers it stylish to buy a product that others have
purchased. Conversely, a negative network externality, the snob eect, occurs
when the quantity demanded increases when fewer people own the good.
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Exercises 3
Problem 1
Explain the dierence 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 eect and a substitution eect
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Microeconomics
Exercises 3
Problem 2
Suppose that a consumer spends a xed amount of income per month on the
following pairs of goods:
1
tortilla chips and salsa
2
tortilla chips and potatoe chips
3
movie tickets and gourmet coee
4
travel by bus and travel by subway
If the price of one of the goods increases, explain the eect on the quantity
demanded of each of the goods. In each pair, which are likely to be complements
and which are likely to be substitutes?
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Microeconomics
Winter Term 2009/2010
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Exercises 3
Problem 3
For which of the following goods is a price increase likely to lead to a substantial
income (as well as substitution) eect?
1
salt
2
housing
3
theater tickets
4
food
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Microeconomics
Winter Term 2009/2010
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Exercises 3
Problem 4
The director of a theater company in a small college town is considering changing
the way he prices tickets. He has hired an economic consulting rm to estimate
the demand for tickets. The rm has classied people who go to the theater into
two groups, and has come up with two demand functions. The demand curves for
the 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 and
Q on the horizontal axis. If the current price of tickets is $35, identify the
quantity demanded by each group.
2 Find the price elasticity of demand for each group at the current price and
quantity.
3 Is the director maximizing the revenue he collects from ticket sales by
charging $35 for each ticket? Explain.
4 What price should he charge each group if he wants to maximize revenue
collected from ticket sales?
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Exercises 3
Problem 5
By observing an individual's behavior in the situations outlined below, determine
the relevant income elasticities of demand for each good (i.e. whether the good is
normal or inferior). If you cannot determine the income elasticity, what additional
information do you need?
1
Bill spends all his income on books and coee. He nds $20 while
rummaging through a used paperback bin at the bookstore. He immedeately
buys a new hardcover book of poetry.
2
Bill loses $10 he was going to buy a doule espresso. He decides to sell his
new book at a discount to a friend and use the money to buy coee.
3
Coee and book prices rise by 25 percent. Bill lowers his consumption of
both goods by the same percentage.
4
Bill drops out of art school and gets an M.B.A. instead. He stops reading
books and drinking coee. Now he reads The Wall Street Journal and drinks
bottled mineral water.
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