Individual and

1

• Chapter 4
• Individual and
• Market Demand

2
Effects of changes in price

• The price consumption curve
• Hold income and the prices of other goods
  constant
• Keep reducing the price of shelter and find the
  new optimal bundles
• The price consumption curve is the set of these
  optimal bundles

3

• FIGURE 4-1
• The Price-Consumption Curve
• Holding income and the price of Y fixed, we vary
  the price of shelter. The set of optimal bundles
  traced out by the various budget lines is called
  the price-consumption curve, or PCC.

4

• The individual consumers demand curve
• Record the different prices and corresponding
  quantities of shelter (optimal choice of shelter)
• This is the individuals demand schedule for
  shelter
• All other factors (income, prices of related
  goods) are held constant
• We focus on how quantity demanded reacts to
  changes in the products own price

5

• TABLE 4-1
• A Demand Schedule
• To derive the individuals demand curve for
  shelter from the PCC in Figure 4-1, begin by
  recording the quantities of shelter that
  correspond to the shelter prices on each budget
  constraint.

6
Effects of changes in income

• The income-consumption curve
• Hold all prices constant
• Increase income and find the optimal points
• The income-consumption curve is the set of these
  points
• The Engel curve
• Shows the relationship between the quantity of
  the good consumed and income
• Normal and inferior goods
• Normal goods upward sloping Engel curve
• Inferior goods downward sloping Engel curve

7

• FIGURE 4-3
• An Income-Consumption Curve
• As income increases, the budget constraint moves
  outward. Holding preferences and relative prices
  constant, the ICC traces out how these changes in
  income affect consumption. It is the set of all
  tangencies as the budget line moves outward.

8

• FIGURE 4-4
• An Individual Consumers Engel Curve
• Holding preferences and relative prices constant,
  the Engel curve tells how much shelter the
  consumer will purchase at various levels of
  income.

9
The income and substitution effects of a price
change

• The total effect of a price change consists of
  the income and substitution effects
• Suppose that the price of X increases
• The substitution effect arises due to the change
  in relative prices
• If the price of good X increases, it is now more
  expensive relative to good Y
• Price and quantity of X purchased always move in
  opposite directions

10

• The income effect arises due to the change in
  purchasing power
• If X is more expensive, the consumers purchasing
  power has gone down
• If X is a normal good, the consumption of X
  decreases
• If X is an inferior good, the consumption of X
  increases
• For normal goods, the income and substitution
  effects work in the same direction
• For inferior goods the income and substitution
  effects work against each other

11

• Assume M120 and Ps6 initially. Then Ps
  increases to 24
• Initially the optimal bundle is A
• After the price increase, the budget constraint
  rotates inward and the new optimal bundle is at
  point D
• The price change caused a movement from A to D
  this is the total effect

12

• FIGURE 4-6
• The Total Effect of a Price Increase
• With an income of 120 per week and a price of
  shelter of 6/sq m, the consumer chooses bundle
  A on the budget constraint B0. When the price of
  shelter rises to 24/sq m, with income held
  constant at 120 per week, the best affordable
  bundle becomes D. The movement from 10 to 2 sq
  m/wk of shelter is called the total effect of the
  price increase.

13
Decomposing the income and substitution effects

• How much income will the consumer need to reach
  the initial indifference curve after the increase
  in the price of shelter?
• Draw a line parallel to the new budget line and
  tangent to the original indifference curve
• The movement from A to C is the substitution
  effect
• The movement from C to D is the income effect
• This decomposition is not directly observable

14

• FIGURE 4-7
• The Substitution and Income Effects of a Price
  Change
• To get the substitution effect, slide the new
  budget B1 outward parallel to itself until it
  becomes tangent to the original indifference
  curve, I0. The movement from A to C gives rise to
  the substitution effect, the reduction in shelter
  due solely to the fact that shelter is now more
  expensive relative to other goods. The movement
  from C to D gives rise to the income effect. It
  is the reduction in shelter that results from the
  loss in purchasing power implicit in the price
  increase.

15

• Substitution effect even if the consumer had
  enough income to reach the original indifference
  curve, he/she would still consume less shelter
  due to the relative price change
• Income effect shelter is a normal good the
  income effect reinforces the substitution effect
• For inferior goods the income and substitution
  effects work in opposite directions

16

• FIGURE 4-8
• Income and Substitution Effects for an Inferior
  Good
• In contrast to the case of a normal good, the
  income effect acts to offset the substitution
  effect for an inferior good.

17
The case of perfect substitutes and complements

• Perfect complements (example 4-1)
• L-shaped indifference curves
• Rotate budget constraint to illustrate the effect
  of the price increase
• Draw a hypothetical new budget constraint
  parallel to the new budget constraint but tangent
  to the original indifference curve
• There is no substitution effect
• The total effect is equal to the income effect

18

• FIGURE 4-9
• Income and Substitution Effects for Perfect
  Complements
• For perfect complements, the substitution effect
  of an increase in the price of bindings (the
  movement from A to C) is equal to zero. The
  income effect (the movement from A to D) and the
  total effect are one and the same.

19

• Perfect substitutes (example 4-2)
• Tea and coffee, Ptea1.2 and Pcoffee1
• Income12/wk
• Initially, corner solution buy only coffee
• Then, Pcoffee1.5
• New corner solution buy only tea
• Substitution effect - from (12,0) to (0,12) (very
  large)
• Income effect - from (0, 12) to (0,10)
• Total effect from (12,0) to (0,10)

20

• FIGURE 4-10
• For perfect substitutes, the substitution effect
  of an increase in the price of coffee (the
  movement from A to C) can be very large.

21
Responsiveness to price changes

• The quantity demanded of some goods changes very
  little as a result of a price change (salt)
  both the income and substitution effects of the
  price change are very small
• The quantity demanded of other goods changes
  considerably as a result of a price change
  (housing) both the income and substitution
  effects are relatively large

22

• FIGURE 4-11
• Income and Substitution Effects of a Price
  Increase for Salt
• The total effect of a price change will be very
  small when (1) the original equilibrium bundle
  lies near the vertical intercept of the budget
  constraint and (2) the indifference curves have a
  nearly right-angled shape. The first factor
  causes the income effect (the reduction in salt
  consumption associated with the movement from C
  to D) to be small the second factor causes the
  substitution effect (the reduction in salt
  consumption associated with the movement from A
  to C) to be small.

23

• FIGURE 4-12
• Income and Substitution Effects for a
  Price-Sensitive Good
• Because shelter occupies a large share of the
  budget, its income effect tends to be large. And
  because it is practical to substitute away from
  shelter, the substitution effect also tends to be
  large. The quantities demanded of goods with both
  large substitution and large income effects are
  highly responsive to changes in price.

24
Individual and market demand

• We can derive the individuals demand curve by
  changing the price of the product and finding the
  optimal quantity using consumer theory
• The market demand curve is the horizontal sum of
  all individual demand curves
• Can be derived graphically and algebraically

25

• FIGURE 4-15
• Generating Market Demand from Individual Demands
• The market demand curve (D in the right panel) is
  the horizontal sum of the individual demand
  curves, D1 (left panel) and D2 (centre panel).

26

• Example 4-4
• Suppose that a market consists of only two
  consumers with individual demand curves P30-2Q1
  and P30-3Q2.
• To derive the market demand curve, we have to sum
  up the quantities Q1(30-P)/2 and Q2(30-P)/3
• Market demand QQ1Q215-P/210-P/3 25 5/6P,
  or P 30 6/5Q
• Identical consumers
• Suppose that a market consists of n identical
  consumers with demand curves Pa bQi
• Then Qia/b (1/b)P
• Market demand QnQina/b-(n/b)P, or
• Pa (b/n)Q

27
Price elasticity of demand

• Percent change in quantity demanded resulting
  from a 1 change in price (formula)
• Interpreting the elasticity coefficient
• Geometric interpretation P/Q x 1/slope (point
  slope method)
• Demand elasticity is different at every point
• Demand elasticity is always negative (ignore -)
• On a straight line demand curve, elasticity is
  inversely related to the slope

28

• Elasticity and total expenditure will an
  increase in price cause an increase in total
  expenditure?
• A small increase in price will cause expenditure
  to increase if demand is inelastic
• A small reduction in price will cause an increase
  in expenditure if demand is elastic
• Determinants of price elasticity
• Substitution possibilities
• Budget share
• Direction of income effect
• time

29

• FIGURE 4-23
• Demand and Total Expenditure
• When demand is elastic, total expenditure changes
  in the opposite direction from a change in price.
  When demand is inelastic, total expenditure and
  price both move in the same direction. At the
  midpoint of the demand curve (M), total
  expenditure is at a maximum.

30
Income elasticity of demand

• Measured by the percent change in quantity
  demanded for a given percent change in income
• Normal goods- positive income elasticity
• Inferior goods negative income elasticity

31
Cross-price elasticity of demand

• Measured as the percent change in the quantity
  demanded for good X as a result of a given
  percent change in the price of good Y.
• Complements negative cross price elasticity
• Substitutes positive cross price elasticity