Individual Demand Curves

1
Chapter 3

• Individual Demand Curves

2
Individual Demand Curves

• This chapter studies how people change their
  choices when conditions such as income or changes
  in the prices of goods affect the amount that
  people choose to consume.
• This chapter then compares the new choices with
  those that were made before conditions changed
• The main result of this approach is to construct
  an individuals demand curve

3
Demand Functions

• If we knew a persons preferences and all the
  economic forces that affect his or her choices,
  we could predict how much of each good would be
  chosen.
• This summarizes this information in a demand
  function a representation of how quantity
  demanded depends on prices, income, and
  preferences.

4
Demand Function

• The three elements that determine the quantity
  demanded are the prices of X and Y, the persons
  income (I), and the persons preferences for X
  and Y.
• Preferences appear to the right of the semicolon
  because we assume that preferences do not change
  during the analysis.

5
Homogeneous Demand Function

• Individual demand functions are homogeneous since
  quantity demanded does not change when prices and
  income increase in the same proportion.
• The budget constraint PXX PYY I is identical
  to the budget constraint 2PXX 2PYY 2I.
• Graphically the lines are the same.

6
Changes in Income

• When a persons income increase, while prices
  remain the same, the quantity purchased of each
  good might increase.
• This situation is shown in Figure 3.1 where the
  increase in income is shown as the budget line
  shifts out from I1 to I2 to I3.
• The slope of the budget lines are the same since
  the prices have not changed .

7
FIGURE 3.1 Effect of Increasing Income on
Quantities of X and Y Chosen
Quantity of Y per week
Y1
U1
I1
Quantity of X per week
X1
0
8
FIGURE 3.1 Effect of Increasing Income on
Quantities of X and Y Chosen
Quantity of Y per week
Y2
U2
Y1
U1
I2
I1
Quantity of X per week
X1
0
X2
9
FIGURE 3.1 Effect of Increasing Income on
Quantities of X and Y Chosen
Quantity of Y per week
Y3
Y2
U3
U2
Y1
U1
I2
I3
I1
Quantity of X per week
X1
0
X2
X3
10
Changes in Income

• In response to the increase in income the
  quantity of X purchased increases from X1 to X2
  and X3 while the quantity purchased of Y also
  increases from Y1 to Y2 to Y3.
• Increases in income make it possible for a person
  to consume more reflected in the outward shift in
  the budget constraint that allows an increase in
  overall utility.

11
Normal Goods

• A normal good is one that is bought in greater
  quantities as income increases.
• If the quantity increases more rapidly than
  income the good is called a luxury good as with
  good Y in Figure 3.1.
• If the quantity increases less rapidly than
  income the good is called a necessity good as
  with good X in Figure 3.1.

12
APPLICATION 3.1 Engels Law

• One important generalization about consumer
  behavior is that the fraction of income spent on
  food tends to decline as income increases.
• This finding was discovered by Prussian
  economists Ernst Engel (1821-1896).
• Table 1 show Engels data with Table 2 showing
  recent data for U.S. consumers.

13
TABLE 1 Percentage of Total Expenditures of
Various Items in Belgian Families in 1853
14
TABLE 2 Percentage of Total Expenditures by U.S.
Consumers on Various Items, 2000
15
Inferior Goods

• An inferior good is one that is bought in smaller
  quantities as income increases.
• In Figure 3.2 as income increases from I1 to I2
  to I3, the consumption of inferior good Z
  decreases.
• Goods such as rotgut whiskey, potatoes, and
  secondhand clothing are examples of inferior
  goods.

16
FIGURE 3.2 Indifference Curve Map Showing
Inferiority
Quantity of Y per week
Y1
U1
I1
Z1
Quantity of Z per week
0
17
FIGURE 3.2 Indifference Curve Map Showing
Inferiority
Quantity of Y per week
Y2
U2
Y1
U1
I2
I1
Z2
Z1
Quantity of Z per week
0
18
FIGURE 3.2 Indifference Curve Map Showing
Inferiority
Quantity of Y per week
Y3
U3
Y2
U2
Y1
U1
I1
I2
I3
Z2
Z1
Quantity of Z per week
Z3
0
19
Changes in a Goods Price

• A change in the price of one good causes both the
  slope and an intercept of the budget line to
  change.
• The change also involves moving to a new
  utility-maximizing choice on another indifference
  curve with a different MRS.
• The quantity demanded of the good whose price has
  changed changes.

20
Substitution Effect

• The part of the change in quantity demanded that
  is caused by substitution of one good for another
  is called the substitution effect.
• This results in a movement along an indifference
  curve.
• Consumption has to be changed to equate MRS to
  the new price ratio of the two goods.

21
Income Effect

• The part of the change in quantity demanded that
  is caused by a change in real income is called
  the income effect.
• The price change also changes real purchasing
  power and consumers will move to a new
  indifference curve that is consistent with this
  new purchasing power.

22
Substitution and Income Effects from a Fall in
Price

• As shown in Figure 3.3, when the price of good X
  falls, the budget line rotates out from the
  unchanged Y axis so that the X intercept lies
  father out because the consumer can now buy more
  X with the lower price.
• The flatter slope means that the relative price
  of X to Y (PX/PY) has fallen.

23
Substitution Effect from a Fall in Price

• The consumer was originally maximizing utility at
  X, Y in Figure 3.3.
• After the fall in the price of good X, the new
  utility maximizing choice is X, Y.
• The substitution effect is the movement on the
  original indifference curve to point B.

24
FIGURE 3.3 Income and Substitution Effects of a
Fall in Price
Quantity of Y per week
Y
U1
X
0
Quantity of X per week
25
FIGURE 3.3 Income and Substitution Effects of a
Fall in Price
Quantity of Y per week
Old budget constraint
Y
B
New budget constraint
U1
X
XB
0
Quantity of X per week
Substitution effect
26
FIGURE 3.3 Income and Substitution Effects of a
Fall in Price
Quantity of Y per week
Old budget constraint
Y
Y
U2
B
New budget constraint
U1
Quantity of X per week
X
XB
X
0
Substitution effect
Income effect
Total increase in X
27
Substitution Effect from a Fall in Price

• If the individual had to stay on the U1 with the
  new price ratio, the consumer would choose B
  since that is the point where the MRS is equal to
  the slope of the new budget line (shown by the
  dashed line).
• Staying on the same indifference curve is the
  same as holding real income constant.
• The consumer buys more good X.

28
Income Effect

• The movement from point B to X, Y results
  from the increase in purchasing power.
• Because PX falls but nominal income (I) remains
  the same, the individuals real income
  increases so that he or she can be on utility
  level U3.
• The consumer buys more good X.

29
The Effects Combined

• Using the hamburger-soft drink example from
  Chapter 2, suppose the price of soft drinks falls
  from .50 to .25.
• Previously the consumer could purchase up to 20
  soft drinks, but now he or she can purchase up to
  40.
• This price decrease shifts the budget line
  outward and increases utility.

30
The Effects Combined

• If the consumer bought his or her previous choice
  it would now cost 7.50 so that 2.50 would be
  unspent.
• If the individual stayed on the old indifference
  curve he or she would equate MRS to the new price
  ratio (consuming 1 hamburger and 4 soft drinks).
• This move is the substitution effect.

31
The Effects Combined

• Even with constant real income the consumer will
  buy more soft drinks since the opportunity cost
  of eating a burger in terms of the soft drinks
  forgone is now higher.
• Since real income has increased the person will
  choose to buy more soft drinks so long as soft
  drinks are a normal good.

32
Substitution and Income Effects from an Increase
in Price

• An increase in PX will shift the budget line in
  as shown in Figure 3.4.
• The substitution effect, holding real income
  constant, is the move on U2 from X, Y to point
  B.
• Because the higher price causes purchasing power
  to decrease, the movement from B to X, Y is
  the income effect.

33
FIGURE 3.4 Income and Substitution Effects of an
Increase in Price
Quantity of Y per week
U2
New budget constraint
Y
Old budget constraint
Quantity of X per week
X
0
34
FIGURE 3.4 Income and Substitution Effects of an
Increase in Price
Quantity of Y per week
U2
U1
B
New budget constraint
Y
Old budget constraint
Quantity of X per week
XB
X
0
Substitution effect
35
FIGURE 3.4 Income and Substitution Effects of an
Increase in Price
Quantity of Y per week
U2
U1
B
Y
New budget constraint
Y
Old budget constraint
Quantity of X per week
X
XB
X
0
Income effect
Substitution effect
Total reduction in X
36
Substitution and Income Effects from an Increase
in Price

• In Figure 3.4, both the substitution and income
  effects cause the individual to purchase less
  soft drinks do to the higher price of soft drinks.

37
Substitution and Income Effects for a Normal
Good Summary

• As shown in Figures 3.3 and 3.4, the substitution
  and income effects work in the same direction
  with a normal good.
• When the price falls, both the substitution and
  income effects result in more purchased.
• When the price increases, both the substitution
  and income effects result in less purchased.

38
Substitution and Income Effects for a Normal
Good Summary

• This provides the rational for drawing downward
  sloping demand curves.
• This also helps to determine the steepness of the
  demand curve.
• If either the substitution or income effects are
  large, the change in quantity demanded will be
  large with a given price change.

39
Substitution and Income Effects for a Normal
Good Summary

• If the substitution and income effects are small,
  the effect of a given price change in the
  quantity demanded will also be small.
• This kind of analysis also offers a number of
  insights about some commonly used economic
  statistics.

40
APPLICATION 3.2 The Consumer Price Index and Its
Biases

• The Bureau of Labor Statistics monthly calculates
  the Consumer Price Index (CPI) which is a
  principal measure of inflation in the U.S..
• To construct the CPI, a typical market basket of
  commodities purchased by consumers in the base
  year (currently 1982) is calculated.

41
APPLICATION 3.2 The Consumer Price Index and Its
Biases

• The ratio of the current cost of the basket to
  the base year price is the measure of the value
  of the CPI.
• The rate of change in the CPI between two periods
  is the reported rate of inflation.

42
An Algebraic Example

• Suppose the 1982 typical market basket contained
  X82 of good X and Y82 of good Y.
• The prices of these goods are and
• The cost of this bundle in the 1982 base year
  would be written as

43
An Algebraic Example

• To compute the cost of the same bundle of goods
  in, say 2002, requires that we compute the cost
  of the bundle using current prices

44
An Algebraic Example

• The CPI is defined as the ratio of the costs of
  these two market baskets
• If the basket cost 100 in 1982 prices and 180
  in 2002, the value of the CPI would be 1.80 and
  with a measured 80 percent increase in prices
  over the 20 year period.

45
Substitution Bias in the CPI

• The CPI does not take into account the real
  possibility that consumers would substitute among
  commodities because of changes in relative
  prices.
• In Figure 1, the typical individual is initially
  consuming X82, Y82 maximizing utility on U1 with
  1982 constraint I.

46
FIGURE 1 Substitution Bias of the Consumer Price
Index
Quantity of Y per year
Y82
U1
I
I
I
0
Quantity of X per year
X82
47
Substitution Bias in the CPI

• Suppose the 2002 relative prices change so that
  PX/PY falls.
• The cost of the 1982 bundle in terms of 2002
  prices is reflected in the constraint I which is
  flatter and goes though the 1982 bundle.
• The consumer would substitute X for Y and stay on
  U1 on budget line I.

48
Substitution Bias in the CPI

• Since I is inside I (which is used to compute
  the CPI), the CPI tends to overstate the
  inflation rate.
• Unfortunately, adjusting the CPI to take such
  substitution into account is difficult because it
  would require that we know the utility function
  of the typical consumer.

49
New Product Bias in the CPI

• New products typically experience sharp declines
  in prices and rapidly grow in rates of
  acceptance.
• If the CPI does not include these new products,
  this source of welfare increase is omitted.
• The CPI basket is revised but not rapidly enough
  to eliminate this bias.

50
Outlet Bias in the CPI

• The typical basket is bought at the same retail
  outlets every month.
• This method can omit the benefits of sales or
  other bargains.
• The CPI does not currently take such
  price-reducing strategies and thus tends to
  overstate inflation.

51
Consequences of the CPI Biases

• Measuring and correcting for these biases is not
  an easy task.
• The CPI is such a widely used measure of
  inflation that any change becomes a hot political
  issue.
• However, there is a general agreement that the
  CPI overstates inflation by as much as 0.75 to
  1.0 percent per year.

52
Consequences of the CPI Biases

• Politicians have proposed caps on Cost of Living
  Adjustments (COLAs) tied to the CPI on government
  programs, but none have yet been enacted.
• However, the private sector has adjusted so that
  few private COLAs provide full offsets to
  inflation measured by the CPI.

53
Substitution and Income Effects for Inferior Goods

• With an inferior good, the substitution effect
  and the income effects work in opposite
  directions.
• The substitution effect results in decreased
  consumption for a price increase and increased
  consumption for a price decrease.

54
Substitution and Income Effects for Inferior Goods

• The income effect results in increased
  consumption for a price increase and decreased
  consumption for a price decrease.
• Figure 3.5 shows the two effects for an increase
  in PX.
• The substitution effect, holding real income
  constant, is shown by the move from X, Y to
  point B both on U2.

55
FIGURE 3.5 Income and Substitution Effects for
an Inferior Good
Quantity of Y per week
Y
U2
Old budget constraint
0
Quantity of X per week
X
56
FIGURE 3.5 Income and Substitution Effects for
an Inferior Good
Quantity of Y per week
B
New budget constraint
Y
U2
Y
Old budget constraint
U1
0
Quantity of X per week
X
57
FIGURE 3.5 Income and Substitution Effects for
an Inferior Good
Quantity of Y per week
B
New budget constraint
Y
U2
Y
Old budget constraint
Xb
U1
0
Quantity of X per week
X
X
58
Substitution and Income Effects for Inferior Goods

• The income effect reflects the reduced purchasing
  power due to the price increase.
• Since X is an inferior good, the decrease in
  income results in an increase in the consumption
  of X shown by the move from point B on U1 to the
  new utility maximizing point X, Y on U1.

59
Substitution and Income Effects for Inferior Goods

• Since X is less than X the price increase in X
  results in a decrease in the consumption of X.
• This occurs because the substitution effect, in
  this example, is bigger than the income effect.
• Thus, if the substitution effect dominates, the
  demand curve is negatively sloped.

60
Giffens Paradox

• If the income effect of a price change is strong
  enough with an inferior good, it is possible for
  the quantity demanded to change in the same
  direction as the price change.
• Legend has it that this phenomenon was observed
  by English economist Robert Giffen.

61
Giffens Paradox

• When the price of potatoes rose in Ireland the
  consumption of potatoes also increased.
• Potatoes were not only an inferior good but
  constituted the source of a large portion of
  Irish peoples income.
• The situation I which an increase in a goods
  price leads people to consume more of the good is
  called Giffens paradox.

62
FIGURE 3.5 Income and Substitution Effects for
an Inferior Good
Quantity of Y per week
B
New budget constraint
Y
U2
Y
Old budget constraint
Xb
U1
0
Quantity of X per week
X
X
63
FIGURE 3.5 Income and Substitution Effects for
an Inferior Good
Quantity of Y per week
B
New budget constraint
Y
U2
Y
Old budget constraint
Xb
U1
0
Quantity of X per week
X
X
64
FIGURE 3.5 Income and Substitution Effects for a
Giffen Good
Quantity of Y per week
New budget constraint
B
Y
U2
Old budget constraint
Y
U1
Xb
0
Quantity of X per week
X
X
65
The Lump Sum Principle

• The lump-sum principle hold that taxes that are
  imposed on general purchasing power will have a
  smaller welfare costs than will taxes imposed on
  a narrow selection of commodities.
• Consider Figure 3.6 where the individual
  initially has I dollars to spend and chooses to
  consume X and Y yielding U3 utility.

66
FIGURE 3.6 The Lump-Sum Principle
Quantity of Y
I
Y
U3
Quantity of X per week
X
67
The Lump Sum Principle

• A tax on only good X raises its price resulting
  in budget constraint I and consumption reduced
  to X1, Y1 and utility level U1.
• A general income tax that generates the same
  total tax revenue is represented by budget
  constraint I that goes though X1, Y1.

68
FIGURE 3.6 The Lump-Sum Principle
Quantity of Y
I
Y1
Y
I
Y2
U3
U1
Quantity of X per week
X1
X
69
FIGURE 3.6 The Lump-Sum Principle
Quantity of Y
I
Y1
Y
I
I
Y2
U3
U2
U1
Quantity of X per week
X1
X2
X
70
The Lump Sum Principle

• The utility maximizing choice on I is X2, Y2
  yielding utility level U2.
• The lump-sum general income tax generates the
  same amount of tax revenue but leaves the
  consumer on a higher utility level (U2) than the
  utility level associated with the tax only on
  good X (U1).

71
The Lump Sum Principle

• The intuitive explanation of the lump-sum
  principle is that a single-commodity tax affects
  people in two ways
• it reduces their purchasing power,
• it directs consumption away from the good being
  taxed.
• The lump-sum tax only has the first of these two
  effects.

72
Generalizations of the Lump-Sum Principle

• The utility lass associated with the need to
  collect a certain amount of tax revenue will be
  minimized by taxing goods for which the
  substitution effect is small.
• Even though the tax will reduce purchasing power,
  it will minimize the impact of directing
  consumption away from the good being taxed.

73
APPLICATION 3.3 Wouldnt Cash Be a Better Way to
Help Poor People?

• The lump-sum principle suggests that the trends
  in expanding in-kind programs may be unfortunate
• These programs do not generate as much welfare
  for people as would the spending of the same
  funds in a cash program

74
APPLICATION 3.3 Wouldnt Cash Be a Better Way to
Help Poor People?

• In Figure 1 a subsidy on good X (constraint I)
  raises utility to U2
• For the same funds, an income grant (I) raises
  utility to U3

75
FIGURE 1 The Superiority of an Income Grant
Y per period
I
U3
I
B
U2
I
U1
X per period
76
Changes in the Price of Another Good

• When the price of one good changes, it usually
  has an effect on the demand for the other good.
• The decrease in the price of X (a normal good)
  caused both an income and substitution effect
  that caused an increase in the quantity demanded
  of X.

77
Income and Substitution Effects of a Fall in Price
Quantity of Y per week
Old budget constraint
Y
Y
U2
B
YB
New budget constraint
U1
Quantity of X per week
X
XB
X
0
Substitution effect
Income effect
Total increase in X
78
Changes in the Price of Another Good

• In addition, the substitution effect caused a
  decrease in the demand for good Y as the consumer
  substituted good X for good Y.
• However, the increase in purchasing power brought
  about by the price decrease causes an increase in
  the demand for good Y (also a normal good).

79
Changes in the Price of Another Good

• Since, in this case, the income effect had a
  dominant effect on good Y, the consumption of Y
  increased due to a decrease in the price of good
  X.
• With flatter indifference curves as shown in
  Figure 3.7, the situation is reversed.
• A decrease in the price of good X causes a
  decrease in good Y, as before.

80
FIGURE 3.7 Effect on the Demand for Good Y of a
Decrease in the Price of Good X
Quantity of Y per week
Old budget constraint
Y
U1
0
Quantity of X per week
X
81
FIGURE 3.7 Effect on the Demand for Good Y of a
Decrease in the Price of Good X
Quantity of Y per week
Old budget constraint
A
Y
New budget constraint
B
U2
U1
0
Quantity of X per week
X
82
FIGURE 3.7 Effect on the Demand for Good Y of a
Decrease in the Price of Good X
Quantity of Y per week
Old budget constraint
A
Y
C
Y
New budget constraint
B
YB
U2
U1
0
Quantity of X per week
X
X
83
Substitutes

• Substitutes are goods that are used for
  essentially the same purpose.
• Two goods such that if the price of one
  increases, the demand for the other rises are
  substitutes.
• If the price of one good decreases and the demand
  for the other good decreases, they are also
  substitutes.

84
Complements

• Complements are goods that go together in the
  sense that people will increase their use of both
  goods simultaneously.
• Two goods are complements if an increase in the
  price of one causes a decrease in the quantity
  demanded of the other or a decrease in the price
  of one good causes an increase in the demand for
  the other.

85
APPLICATION 3.4 Why Are So Many Trucks on the
Road?

• In the 1990s, virtually all new vehicle
  registrations were trucks, mostly SUVs
• Sharp decline in real gasoline prices
• In 1980s, gas cost 1.5 per gallon
• In 1999, it cost 1.1 per gallon
• Adjusted for inflation, it is a fall of 40 in
  real terms
• Opportunity costs of operating trucks has thus
  decreased, causing substitution effect
• Regulation Corporate Average Fuel Economy
  standards did not cover SUVs
• By September 2005, 1 gallon of gas cost 3.00
• Sales of large SUVs slumped in 2004-2005
• By 2005 the CAFE standards started to include
  SUVs as well

86
Construction of Individual Demand Curves

• An individual demand curve is a graphic
  relationship between the price of a good and the
  quantity of it demanded by a person holding all
  other factors (preferences, the prices of other
  goods, and income) constant.
• Demand curves limit the study to the relationship
  between the quantity demanded and changes in the
  own price of the good.

87
FIGURE 3.8 Construction of an Individuals
Demand Curve
Quantity of Y
per week
Budget constraint for P
9
X
U
1
Quantity of X
X
0
per week
(a) Individual

s indifference curve map
Price
PX
Quantity of X
X
0
per week
(b) Demand curve
88
FIGURE 3.9 Construction of an Individuals
Demand Curve
Quantity of Y
Budget constraint for PX
per week
Budget constraint for PX
U
2
U
1
Quantity of X
X
X
X
0
per week
(a) Individual

s indifference curve map
Price
PX
PX
Quantity of X
X
X
0
per week
(b) Demand curve
89
FIGURE 3.8 Construction of an Individuals
Demand Curve
Quantity of Y
Budget constraint for PX
per week
Budget constraint for PX
Budget constraint for PX
U
3
U
2
U
1
Quantity of X
X
X
X
0
per week
(a) Individual

s indifference curve map
Price
P
9
X
P
0
X
P
-
X
Quantity of X
X
X
X
0
per week
(b) Demand curve
90
FIGURE 3.8 Construction of an Individuals
Demand Curve
Quantity of Y
Budget constraint for PX
per week
Budget constraint for PX
Budget constraint for PX
U
3
U
2
U
1
Quantity of X
X
X
X
0
per week
(a) Individual

s indifference curve map
Price
P
9
X
P
0
X
P
-
X
d
X
Quantity of X
X
X
X
0
per week
(b) Demand curve
91
Substitutes and Flat Demand

• If a good, say X, has close substitutes, a
  increase in its price will cause a large decrease
  in the quantity demanded as the substitution
  effect will be large.
• The demand curve for a type of breakfast cereal
  will likely be relatively flat due to the strong
  substitution effect.

92
Lack of Substitutes and Steep Demand

• If the good has few substitutes, the substitution
  effect of a price increase or decrease will be
  small and the demand curve will be relatively
  steep.
• Water is an example of a good with few
  substitutes.

93
Special Case Food

• Food has no substitutes so it might be thought
  that no change in consumption would occur with a
  price increase.
• But food constitutes a large part of an
  individuals budget so that price changes will
  cause relatively larger effects on the quantity
  demanded that might be thought due to the income
  effect.

94
FIGURE 3.9 Shifts in Individuals Demand Curve
PX
PX
PX
P1
P1
P1
X
X
X
X1
X1
X1
X2
X2
X2
0
0
0
(a)
(b)
(c)
95
FIGURE 3.10 Shifts in Individuals Demand Curve
PX
PX
PX
P1
P1
P1
X
X
X
X1
X1
X1
X2
X2
X2
0
0
0
(a)
(b)
(c)
Normal Good
Good X is a substitute with Y, and the price of Y
increases
Good X is a complement to Y, and the price of Y
increases
96
Shifts in an Individuals Demand Curve

• Changes in preferences can also shift demand
  curves.
• Demand could shift rightward as a result for an
  increased preference for cold drinks when a
  sudden hot spell occurs.
• Increased environmental consciousness during the
  1980s and 1990s increased the demand for
  recycling and organic food.

97
APPLICATION 3.5 Fads, Seasons, and Health Scares

• Fads (bandwagon effects)
• Widespread use causes additional demand
• When saturation point is reached, demand rapidly
  dwindles
• Impossible to predict which products will catch
  on
• Seasonality
• Easy to predict seasonal demand Christmas trees,
  turkeys for Thanksgiving etc
• Cod in high demand during Lent Catholic
  requirements on dietary restrictions

98
Health Scares

• Smoking reduction in the US after the surgeon
  generals report in 1964
• Cholesterol decline in demand for beef and dairy
  products, also eggs
• 1982 Tylenol accident
• Cyanide tablets inserted in a few Tylenol bottles
• Dramatic drop in demand followed for Tylenol
  (50)
• 1988 cyanide injection in Chilean grapes
• 1993 study on fat content in Chinese food,
  Chinese restaurants suffered
• Krispy Kreme stock in 2000, 1997 European demand
  for US beef

99
Be Careful in Using Terminology

• A movement downward along a stationary demand
  curve in response to a fall in price is called an
  increase in quantity demanded while a rise in the
  price of the good results in a decrease in
  quantity demanded.
• A rightward shift in a demand curve is called an
  increase in demand while a leftward shift is a
  decrease in demand.

100
Consumer Surplus

• The extra value individuals receive from
  consuming a good over what they pay for it is
  called consumer surplus.
• Consumer surplus is also what people would be
  willing to pay for the right to consume a good at
  its current price.
• This concept is used to study the welfare effects
  of price changes.

101
Consumer Surplus

• In graphical terms, consumer surplus is given by
  the area below the demand curve and above the
  market price.
• In Figure 3.11, total consumer surplus is given
  by area AEB (80).

102
FIGURE 3.11 Consumer Surplus from T-Shirt Demand
Price (/shirt)
Price (/shirt)
A
15
11
9
E
B
d
Quantity (shirts)
15
10
20
103
Consumer Surplus and Utility

• Figure 3.12 illustrates the connection between
  consumer surplus and utility

104
FIGURE 3.11 Consumer Surplus and Utility
Initially, the person is at E with utility
U1. He or she would need to be compensated by
amount AB in other goods to get U1 if T-shirts
were not available.
Other Goods
A
B
The individual would be willing to pay BC for the
right to consume T-shirts rather than spending I
only on other goods.
C
E
U1
I
U0
Both distance AB and BC approximate the consumer
surplus area
I
Quantity (shirts)
20
105
Application 3.6 Valuing New Goods
Price
Only the point E is known right after the
introduction of a new product
Consumer surplus from the introduction of a new
product
Economists developed methodologies to determine
the tangency to an indifference curve that is not
observed!
E
New Good
106
New Goods

• Cell Phones
• Gains estimated to be 50 billion
• Not entered into CPI until after 15 years after
  introduction
• Minivans introduced in the US in the 1980s
• Gains of 3 billion over 1984-1988
• Active competition among minivan suppliers
  contributed to this welfare increase