MicroEconomics theory and application 12th by browning an zupan chapter 04

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MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

Chapter 4: Individual and Market Demand

Prepared by Dr Della Lee Sue, Marist College

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Learning Objectives

 Understand how price changes affect consumption choices

 Differentiate between the income and substitution effects associated with a price change on the consumption of a

particular good

 Explain the relation between income and substitution effects

in the case of inferior goods

 Explain how individual demand curves are aggregated to obtain the market demand curve

(continued)

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Learning Objectives (continued)

 Demonstrate how consumer surplus represents the net

benefit, or gain, to an individual from consuming one

market basket instead of another

 Investigate the relationship between own-price elasticity of demand and the price–consumption curve

 Examine network effects: the extent to which an individual consumer’s demand for a good is influenced by other

individuals’ purchases

 Overview the basics of demand estimation

 Derive the Consumer’s Demand Curve Mathematically

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4.1 PRICE CHANGES AND

CONSUMPTION CHOICES

Understand how price changes affect consumption choices.

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Price Changes and Consumption

Choices

 Price-consumption curve: a curve that identifies the

optimal market basket associated with each possible price of

a good, holding constant all other determinants of demand

 The consumer’s demand curve can be derived from the

price-consumption curve

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Figure 4.1 – Derivation of the

Consumer’s Demand Curve

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Some Remarks about the

Demand Curve

 The consumer’s level of well-being varies along the demand curve.

 The prices of other goods are held constant among a demand curve, but the quantities purchased of these other goods can vary.

 At each point on the demand curve, the consumer’s optimality

condition is satisfied:

MRSXO = PX/POwhere “O” refers to “other goods” (composite good).

 The demand curve identifies the marginal benefit associated with

various levels of consumption.

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Figure 4.2 - Do Demand Curves Always Slope Downward?

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4.2 INCOME AND SUBSTITUTION

EFFECTS OF A PRICE CHANGE

Differentiate between the income and substitution effects associated with

a price change on the consumption of a particular good.

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Income and Substitution Effects of a

Price Change

 Income effect – a change in a consumer’s real purchasing

power brought about by a change in the price of a good

 Substitution effect – an incentive to increase consumption

of a good whose price falls, at the expense of other, now relatively more expensive, goods

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Income and Substitution Effects

Illustrated: The Normal-Good Case

 Substitution Effect: change in consumption due to a

change in relative prices, with no change in real income or well-being

 Income Effect: change in consumption due to a change in

real income or well-being, with no change in relative prices

 For a normal good, both effects imply more consumption at

a lower price and less consumption at a higher price

 Demand curve slopes downward

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Remarks about Income and Substitution Effects of a Price Reduction: The Normal-Good Case

 The demand curve for a normal good must therefore be downward

sloping.

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Figure 4.3 - Income and Substitution Effects

of a Price Reduction: The Normal-Good Case

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The Income and Substitution Effects Associated

with a Gasoline Tax-Plus-Rebate Program

 Excise Tax – a tax on a specific good

 Objective: encourage consumers to reduce their use of

gasoline

 What can be done with the tax revenue?

 Tax rebate to consumers

 Reduce the government’s outstanding debt

 Would an excise tax and a tax rebate curtail consumption?

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Figure 4.4 - Tax-Plus-Rebate Program

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4.3 INCOME AND SUBSTITUTION

EFFECTS: INFERIOR GOODS

Explain the relation between income and substitution effects in the case

of inferior goods.

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Income and Substitution Effects

Illustrated: Inferior Goods

Two possibilities:

 Substitution effect > income effect

 Demand curve slopes downward

 Income effect > substitution effect

 Demand curve slopes upward

 Giffen Good

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Figure 4.5 - Income and Substitution

Effects for an Inferior Goods

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4.4 FROM INDIVIDUAL TO MARKET DEMAND

Explain how individual demand curves are aggregated to obtain the

market demand curve.

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From Individual to Market Demand

 Horizontal summation: add quantities of individual demand curves at each price to obtain the market demand curve

 All individual demand curves slope downward => market demand curve slopes downward

 If some individual demand curves slope upward => market demand curve can till slope downward

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Figure 4.6 – Summing Individual

Demands to Obtain Market Demand

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4.5 CONSUMER SURPLUS

Demonstrate how consumer surplus represents the net benefit, or gain, to

an individual from consuming one market basket instead of another.

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Consumer Surplus

 Consumer surplus – a measure of the net gain to consumers from

purchasing a good arising from its cost being below the maximum that consumers are willing to pay

 Total benefit – the total value a consumer derives from a particular

amount of a good and thus the maximum amount the consumer would

be willing to pay for that amount of the good.

 Marginal benefit – the incremental value a consumer derives from

consuming an additional unit of a good and thus the maximum amount the consumer would pay for that additional unit

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Calculating Consumer Surplus

[NOTE: See Figure 4.7]

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Figure 4 7 – Consumer Surplus

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Figure 4.8 - Geometric Calculation of

Consumer Surplus

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Figure 4.9 – The Increase in Consumer Surplus with a Lower Price

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Figure 4.10 - Consumer Surplus and

Indifference Curves

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4.6 PRICE ELASTICITY AND THE

PRICE–CONSUMPTION CURVE

Investigate the relationship between own-price elasticity of demand and the price–consumption curve.

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Price Elasticity and the

Price-Consumption Curve

The slope of the price-consumption curve

(P-C curve) is related to the elasticity of demand:

 Negatively sloped P-C curve: elastic demand

 Horizontal P-C curve: unit elastic demand

 Positively sloped P-C curve: inelastic demand

 U-shaped P-C curve: elastic demand at high prices and inelastic demand at low prices

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Figure 4.11 - Price-Consumption Curves and the Elasticity of Demand

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4.7 NETWORK EFFECTS

Derive the Consumer’s Demand Curve Mathematically.

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Network Effects

Network effects – the extent to which an individual

consumer’s demand for a good is influenced by other

individuals’ purchases

 Bandwagon effect – a positive network effect

 Snob effect – a negative network effect

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The Bandwagon Effect

 It exists whenever the quantity of a good demanded by a

particular consumer is greater the larger the number of other consumers purchasing the same good

 It increases the response in quantity demanded to any

change in price

 The market demand is more price elastic than the individual demand curves

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Figure 4.12 - The Bandwagon Effect

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The Snob Effect

 It occurs when a consumer is less willing to purchase a good the more widespread its usage

 The quantity of a good demanded by a particular individual falls the more widely owned the good is considered to be by other consumers

 The market demand is more inelastic than the individual

demand curves

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Figure 4.13 - Snob Effect

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4.8 THE BASICS OF DEMAND

ESTIMATION

Examine network effects: the extent to which an individual consumer’s demand for a good is influenced by other individuals’ purchases.

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The Basics of Demand Estimation

 Experimentation

 Limitations:

 difficult to allow only one factor to change, holding the other factors constant

 may be incorrect to apply the results obtained from the sample

to the entire population

 Surveys

 Important to choose a representative sample

 Reliability is dependent on respondents’ truthfulness

 Regression analysis (econometrics) – a statistical method that allows

one to estimate the sensitivity of the quantity demanded of a good to determinants such as price and income

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Table 4.1

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Figure 4.14 - Ordinary Least-Squares

Regression

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Regression Analysis

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4.9 DERIVING THE CONSUMER’S

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Deriving the Consumer’s Demand Curve

Mathematically

 The demand curve of a consumer can be derived from the first-order conditions determining the consumer’s optimal choice:

 solve for the quantity demanded of the product, as a function of the price

 The demand curve depends on the exact nature of the

consumer’s preferences as expressed in the utility function

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Deriving the Consumer’s Demand Curve

Mathematically [Equations]

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The Cobb-Douglas Utility Function

[Equations]

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The Cobb-Douglas Utility Function

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