Chapter 4 - Individual and market demand. In this chapter students will be able to: 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.
Prepared by Dr. Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 4: Individual and Market Demand By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 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) Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 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 ownprice 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Understand how price changes affect consumption choices 4.1 PRICE CHANGES AND CONSUMPTION CHOICES Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Price Changes and Consumption Choices Priceconsumption 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 priceconsumption curve Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Figure 4.1 – Derivation of the Consumer’s Demand Curve Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Some Remarks about the Demand Curve The consumer’s level of wellbeing 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/PO where “O” refers to “other goods” (composite good) The demand curve identifies the marginal benefit associated with various levels of consumption Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Figure 4.2 Do Demand Curves Always Slope Downward? Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Differentiate between the income and substitution effects associated with a price change on the consumption of a particular good 4.2 INCOME AND SUBSTITUTION EFFECTS OF A PRICE CHANGE Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 10 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 33 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 34 Figure 4.12 The Bandwagon Effect Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 35 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 36 Figure 4.13 Snob Effect Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 37 Examine network effects: the extent to which an individual consumer’s demand for a good is influenced by other individuals’ purchases 4.8 THE BASICS OF DEMAND ESTIMATION Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 38 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 39 Table 4.1 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 40 Figure 4.14 Ordinary LeastSquares Regression Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 41 Regression Analysis Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 42 Overview the basics of demand estimation 4.9 DERIVING THE CONSUMER’S DEMAND CURVE MATHEMATICALLY* *Denotes digitalonly content Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 43 Deriving the Consumer’s Demand Curve Mathematically The demand curve of a consumer can be derived from the firstorder 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 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 44 Deriving the Consumer’s Demand Curve Mathematically [Equations] Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 45 The CobbDouglas Utility Function [Equations] [continued] Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 46 The CobbDouglas Utility Function [Equations] [continued] Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 47 ... It increases the response in quantity demanded to any change in price The market demand is more price elastic than the individual demand curves Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 34 Figure? ?4. 12 The Bandwagon Effect... 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 ... Investigate the relationship between ownprice elasticity of demand? ?and? ? the price–consumption curve 4. 6 PRICE ELASTICITY? ?AND? ?THE PRICE–CONSUMPTION CURVE Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 29 Price Elasticity? ?and? ?the Price