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INDIFFERENCE CURVE.ppt

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Prashantmittal33

This document discusses individual and market demand. It begins by explaining individual demand curves and how they are derived from indifference curves. A change in price or income leads to movement along the indifference curves and budget lines. It then discusses the income and substitution effects of a price change. The concepts of normal and inferior goods are explained using Engel curves. The document concludes by discussing how market demand curves are derived by summing individual demand curves horizontally.

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Individual and Market Demand
Topics to be Discussed  Individual Demand  Income and Substitution Effects  Market Demand  Consumer Surplus
Topics to be Discussed  Network Externalities  Empirical Estimation of Demand
Individual Demand  Price Changes • Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.
Individual Demand  The Demand Curve • The price-consumption curve traces the utility- maximizing combinations of food and clothing associated with each and every price of food. • The demand curve relates the quantity of food that the consumer will buy to the price of food.
Effect of a Price Change Food (units per month) Clothing (units per month)
Effect of a Price Change Food (units per month) Clothing (units per month) The budget lines illustrate three prices for food--$2 $2
Effect of a Price Change Food (units per month) Clothing (units per month) The budget lines illustrate three prices for food--$2, $1, $2 $1
Effect of a Price Change Food (units per month) Clothing (units per month) The budget lines illustrate three prices for food--$2, $1, and $.50 $2 $1 $0.50
Effect of a Price Change Food (units per month) Clothing (units per month) A U2 U3 B D U1 Three separate indifference curves are tangent to each budget line.
Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2 U3 A B D U1 4 12 20 Three separate indifference curves are tangent to each budget line.
Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2 U3 Price-Consumption Curve B D A U1 4 12 20 The price-consumption curve traces out the utility maximizing market basket for the various prices for food.
Effect of a Price Change Food (units per month) Price of Food $2.00 $1.50 $1.00 $.50 4 12 20 Demand Curve E G H The points E, G, and H correspond to points A, B, and D, respectively.
Individual Demand  Two Important Properties of Demand Curves 1) The level of utility that can be attained changes as we move along the curve.
Individual Demand  Two Important Properties of Demand Curves 2) At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing.
Individual Demand  Income Changes • Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.
Effects of Income Changes Food (units per month) 3 7 4 10 16 5 Clothing (units per month)
Effects of Income Changes Food (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 A U1 Clothing (units per month)
Effects of Income Changes Food (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 A U1 B U2 Clothing (units per month)
Effects of Income Changes Food (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 A U1 B U2 D U3 Clothing (units per month)
Effects of Income Changes Food (units per month) Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 Income-Consumption Curve A U1 B U2 D U3
Effects of Income Changes Food (units per month) Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. $1.00 4 10 16 D1 E
Effects of Income Changes Food (units per month) Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. $1.00 4 10 16 D1 D2 E G
Effects of Income Changes Food (units per month) Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. $1.00 4 10 16 D1 D2 D3 E G H
Individual Demand  Income Changes • The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.
Individual Demand  Income Changes • An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve. • Simultaneously, the increase in income shifts the demand curve to the right.
Individual Demand  Income Changes • If the income-consumption curve has a positive slope, the quantity demanded increases with income and the income elasticity of demand is positive. • The good is a normal good.
Individual Demand  Income Changes • If the income-consumption curve has a negative slope, the quantity demanded decreases with income and the income elasticity of demand is negative. • The good is an inferior good.
An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30
An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A U1
An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A U1 B U2 Both hamburger and steak behave as a normal good, between A and B...
An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A U1 B U2 U3 C …but hamburger becomes and inferior good when the income consumption curve bends backward between B and C.
An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A B U1 B U2 U3 C Income-Consumption Curve …but hamburger becomes and inferior good when the income consumption curve bends backward between B and C.
Individual Demand  Engel Curves • Engel curves relate the quantity of good consumed to income. • If the good is a normal good, the Engel curve is upward sloping. • If the good is an inferior good, the Engel curve is downward sloping.
Engel Curves Food (units per month) 30 4 8 12 10 Income ($ per month) 20 16 0
Engel Curves Food (units per month) 30 4 8 12 10 Income ($ per month) 20 16 Engel curves slope upward for normal goods. 0
Engel Curves Hamburger (units per month) 30 5 10 10 Income ($ per month) 20 0
Engel Curves Hamburger (units per month) 30 5 10 10 Income ($ per month) 20 Engel curves slope backward bending for inferior goods. 0
Engel Curves Hamburger (units per month) 30 5 10 10 Income ($ per month) 20 Engel curves slope backward bending for inferior goods. 0 Inferior Normal
Example: Consume Expenditures in the United States Entertainment 520 894 1,185 1,602 2,018 2,565 4,007 Owned Dwellings 854 1,370 2,122 3,314 4,450 5,616 9,736 Rented Dwellings 1,642 2,128 1,978 1,884 1,802 1,514 748 Health Care 1,034 1,647 1,732 1,881 2,012 2,054 2,703 Food 2,461 3,198 3,971 4,706 5,556 6,273 8,137 Clothing 867 1,068 1,394 1,778 2,215 2,316 3,668 Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above Income Group (1993 $)
Individual Demand  Substitutes and Complements 1) Two goods are considered substitutes if an increase (decrease)in the price of one leads to an increase (decrease) in the quantity demanded of the other. – e.g. Butter and margarine
Individual Demand  Substitutes and Complements 2) Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other. – e.g. CDs and CD players
Individual Demand  Substitutes and Complements • If the price consumption curve is downward- sloping, the two goods are considered substitutes. • If the price consumption curve is upward- sloping, the two goods are considered complements.  They could be both!
Income and Substitution Effects  A fall in the price of a good has two effects. • Consumers experience an increase in real purchasing power. • They will tend to consume more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.
Income and Substitution Effects  Substitution Effect • The substitution effect is the change in an item’s consumption associated with a change in the price of the item, with the level of utility held constant. • When the price of an item declines, the substitution effect always leads to an increase in the quantity of the item demanded.
Income and Substitution Effects  Income Effect • The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant. • When a person’s income increases, the quantity demanded for the product may increase or decrease. – It usually still increases
Income and Substitution Effects  Income Effect • Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.
Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) F1 S C1 Originally, the consumer is at A on budget line RS. A U1
Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 When the price of food falls, consumption increases by F1Fs as the consumer moves to B. U2 B
Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 U2 B E Total Effect Substitution Effect The substitution effect,F1E, (from points AD), changes the relative prices but keeps real income constant. D
Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 The income effect, EF2, (D to B) keeps relative prices constant but increases purchasing power. U2 B E Total Effect Substitution Effect Income Effect D
Income and Substitution Effects-- Inferior Good Food (units per month) O R Clothing (units per month) F1 S Originally, the consumer is at A on budget line RS. A U1
Income and Substitution Effects-- Inferior Good Food (units per month) O R Clothing (units per month) F1 S T A U1 E Substitution Effect The substitution effect,F1E, (from points AD), changes the relative prices but keeps real income constant. D
Income and Substitution Effects-- Inferior Good Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. Total Effect Food (units per month) O R Clothing (units per month) F1 S F2 T A U1 E Substitution Effect D B Income Effect U2
Income and Substitution Effects  A Special Case--The Giffen Good • The income effect may theoretically be large enough to cause the demand curve for a good to slope upward. • This rarely occurs and is of little practical interest.
Market Demand  From Individual to Market Demand • Market demand curves are the horizontal summation of the individuals’ demand curves.
Determining the Market Demand Curve 1 6 10 16 32 2 4 8 13 25 3 2 6 10 18 4 0 4 7 11 5 0 2 4 6 Price Individual A Individual B Individual C Market ($) (units) (units) (units) (units)
Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A The market demand curve is obtained by summing the consumer’s demand curves
Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A DB The market demand curve is obtained by summing the consumer’s demand curves
Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A DB D C The market demand curve is obtained by summing the consumer’s demand curves
Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A DB D C Market Demand The market demand curve is obtained by summing the consumer’s demand curves
Market Demand  Two Important Points 1) The market demand will shift to the right as more consumers enter the market. 2) Factors that influence the demands of many consumers will also affect the market demand.
Market Demand  Point and Arc Elasticities of Demand • Recall: Price elasticity of demand measures the percentage change in the quantity demanded resulting from a percentage change in price. P Q P Q P/P Q/Q EP / /      
Price Elasticity and Consumer Expenditure If Price Increases, If Price Decreases, Demand Expenditures Expenditures Inelastic (Ep<1) Increase Decrease Unit elastic (Ep=1) Are unchanged Are unchanged Elastic (Ep>1) Decrease Increase
Market Demand  Point and Arc Elasticities of Demand • For large price changes (e.g. 20%), the value of elasticity will depend upon where the price and quantity lie on the demand curve.
Market Demand  Point and Arc Elasticities of Demand • Point elasticity measures elasticity at a point on the demand curve. • Its formula is: ope) (P/Q)(1/sl EP 
Market Demand  Problems Using Point Elasticity • We may need to calculate elasticity between two points instead of at a single point. • The price and quantity used as the original will alter the price elasticity of demand. • Using different original values will result in different calculations.
Market Demand  Point and Arc Elasticities of Demand • Arc Elasticity: Arc elasticity uses the average of the initial and final price as the original. • Its formula is: ) /Q P P)( Q/ ( EP   
Example:The Aggregate Demand For Wheat  The demand for U.S. wheat is comprised of domestic demand and export demand.
Example:The Aggregate Demand For Wheat  The domestic demand for wheat is given by the equation: • QDD = 1354 - 70P  The export demand for wheat is given by the equation: • QDE = 2031 - 209P
Example:The Aggregate Demand For Wheat  Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4 to -0.5).
The Aggregate Demand for Wheat Quantity (millions of bushels per year) Price ($/bushel) 0 2 4 6 8 10 12 14 16 18 20 1000 2000 3000 4000 A C B D Domestic Demand Export Demand
The Aggregate Demand for Wheat Quantity (millions of bushels per year) Price ($/bushel) 0 2 4 6 8 10 12 14 16 18 20 1000 2000 3000 4000 A C B D Domestic Demand Export Demand E F Total Demand Total world demand is the horizontal sum of the domestic demand AB and export demand CD.
Consumer Surplus  Consumer surplus is the difference between what a consumer is willing to pay for a good and what the consumer actually pays when buying it.
Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20
Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Market Price
Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 Market Price Consumer Surplus The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually.
Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 The consumer’s actual expenditure is the price times the quantity purchased. Market Price Actual Expenditure Consumer Surplus
Consumer Surplus  The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller.
Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 For goods that cannot be divided into small parts the consumer surplus is the yellow area below the demand curve. Actual Expenditure Demand Curve Market Price Consumer Surplus
Consumer Surplus  Consumer surplus along with aggregate profits allow us to evaluate: 1) Costs and benefits of different market structures 2) Public policies that alter the behavior of consumers and firms
Example: The Value of Clean Air  Air is free in the sense that we need not pay to breathe it.  The Clean Air Act was amended in 1970.  Question: Were the benefits of cleaning up the air worth the costs?
Example: The Value of Clean Air  People pay more to buy houses where the air is clean.  Data for house prices among neighborhoods of Boston and Los Angeles were compared with the various air pollutants.
Valuing Clean Air NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 0 1000 2000 5 10
Valuing Clean Air NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 0 1000 2000 5 10
Valuing Clean Air NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 0 1000 2000 5 10 A The shaded area gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrous oxide at a cost of $1000 per part reduced.

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INDIFFERENCE CURVE.ppt

  • 2. Topics to be Discussed  Individual Demand  Income and Substitution Effects  Market Demand  Consumer Surplus
  • 3. Topics to be Discussed  Network Externalities  Empirical Estimation of Demand
  • 4. Individual Demand  Price Changes • Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.
  • 5. Individual Demand  The Demand Curve • The price-consumption curve traces the utility- maximizing combinations of food and clothing associated with each and every price of food. • The demand curve relates the quantity of food that the consumer will buy to the price of food.
  • 6. Effect of a Price Change Food (units per month) Clothing (units per month)
  • 7. Effect of a Price Change Food (units per month) Clothing (units per month) The budget lines illustrate three prices for food--$2 $2
  • 8. Effect of a Price Change Food (units per month) Clothing (units per month) The budget lines illustrate three prices for food--$2, $1, $2 $1
  • 9. Effect of a Price Change Food (units per month) Clothing (units per month) The budget lines illustrate three prices for food--$2, $1, and $.50 $2 $1 $0.50
  • 10. Effect of a Price Change Food (units per month) Clothing (units per month) A U2 U3 B D U1 Three separate indifference curves are tangent to each budget line.
  • 11. Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2 U3 A B D U1 4 12 20 Three separate indifference curves are tangent to each budget line.
  • 12. Effect of a Price Change Food (units per month) Clothing (units per month) 4 5 6 U2 U3 Price-Consumption Curve B D A U1 4 12 20 The price-consumption curve traces out the utility maximizing market basket for the various prices for food.
  • 13. Effect of a Price Change Food (units per month) Price of Food $2.00 $1.50 $1.00 $.50 4 12 20 Demand Curve E G H The points E, G, and H correspond to points A, B, and D, respectively.
  • 14. Individual Demand  Two Important Properties of Demand Curves 1) The level of utility that can be attained changes as we move along the curve.
  • 15. Individual Demand  Two Important Properties of Demand Curves 2) At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing.
  • 16. Individual Demand  Income Changes • Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.
  • 17. Effects of Income Changes Food (units per month) 3 7 4 10 16 5 Clothing (units per month)
  • 18. Effects of Income Changes Food (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 A U1 Clothing (units per month)
  • 19. Effects of Income Changes Food (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 A U1 B U2 Clothing (units per month)
  • 20. Effects of Income Changes Food (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 A U1 B U2 D U3 Clothing (units per month)
  • 21. Effects of Income Changes Food (units per month) Clothing (units per month) An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. 3 7 4 10 16 5 Income-Consumption Curve A U1 B U2 D U3
  • 22. Effects of Income Changes Food (units per month) Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. $1.00 4 10 16 D1 E
  • 23. Effects of Income Changes Food (units per month) Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. $1.00 4 10 16 D1 D2 E G
  • 24. Effects of Income Changes Food (units per month) Price of food An increase in income, with the prices fixed, shifts the consumer’s demand curve to the right. Points E, G and H correspond to A, B, and D on the previous graph respectively. $1.00 4 10 16 D1 D2 D3 E G H
  • 25. Individual Demand  Income Changes • The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.
  • 26. Individual Demand  Income Changes • An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve. • Simultaneously, the increase in income shifts the demand curve to the right.
  • 27. Individual Demand  Income Changes • If the income-consumption curve has a positive slope, the quantity demanded increases with income and the income elasticity of demand is positive. • The good is a normal good.
  • 28. Individual Demand  Income Changes • If the income-consumption curve has a negative slope, the quantity demanded decreases with income and the income elasticity of demand is negative. • The good is an inferior good.
  • 29. An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30
  • 30. An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A U1
  • 31. An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A U1 B U2 Both hamburger and steak behave as a normal good, between A and B...
  • 32. An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A U1 B U2 U3 C …but hamburger becomes and inferior good when the income consumption curve bends backward between B and C.
  • 33. An Inferior Good Hamburger (units per month) 15 5 10 20 5 Steak (units per month) 10 30 A B U1 B U2 U3 C Income-Consumption Curve …but hamburger becomes and inferior good when the income consumption curve bends backward between B and C.
  • 34. Individual Demand  Engel Curves • Engel curves relate the quantity of good consumed to income. • If the good is a normal good, the Engel curve is upward sloping. • If the good is an inferior good, the Engel curve is downward sloping.
  • 35. Engel Curves Food (units per month) 30 4 8 12 10 Income ($ per month) 20 16 0
  • 36. Engel Curves Food (units per month) 30 4 8 12 10 Income ($ per month) 20 16 Engel curves slope upward for normal goods. 0
  • 37. Engel Curves Hamburger (units per month) 30 5 10 10 Income ($ per month) 20 0
  • 38. Engel Curves Hamburger (units per month) 30 5 10 10 Income ($ per month) 20 Engel curves slope backward bending for inferior goods. 0
  • 39. Engel Curves Hamburger (units per month) 30 5 10 10 Income ($ per month) 20 Engel curves slope backward bending for inferior goods. 0 Inferior Normal
  • 40. Example: Consume Expenditures in the United States Entertainment 520 894 1,185 1,602 2,018 2,565 4,007 Owned Dwellings 854 1,370 2,122 3,314 4,450 5,616 9,736 Rented Dwellings 1,642 2,128 1,978 1,884 1,802 1,514 748 Health Care 1,034 1,647 1,732 1,881 2,012 2,054 2,703 Food 2,461 3,198 3,971 4,706 5,556 6,273 8,137 Clothing 867 1,068 1,394 1,778 2,215 2,316 3,668 Expenditure Less than 1,000- 20,000- 30,000- 40,000- 50,000- 70,000- ($) on: $10,000 19,000 29,000 39,000 49,000 69,000 and above Income Group (1993 $)
  • 41. Individual Demand  Substitutes and Complements 1) Two goods are considered substitutes if an increase (decrease)in the price of one leads to an increase (decrease) in the quantity demanded of the other. – e.g. Butter and margarine
  • 42. Individual Demand  Substitutes and Complements 2) Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other. – e.g. CDs and CD players
  • 43. Individual Demand  Substitutes and Complements • If the price consumption curve is downward- sloping, the two goods are considered substitutes. • If the price consumption curve is upward- sloping, the two goods are considered complements.  They could be both!
  • 44. Income and Substitution Effects  A fall in the price of a good has two effects. • Consumers experience an increase in real purchasing power. • They will tend to consume more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.
  • 45. Income and Substitution Effects  Substitution Effect • The substitution effect is the change in an item’s consumption associated with a change in the price of the item, with the level of utility held constant. • When the price of an item declines, the substitution effect always leads to an increase in the quantity of the item demanded.
  • 46. Income and Substitution Effects  Income Effect • The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant. • When a person’s income increases, the quantity demanded for the product may increase or decrease. – It usually still increases
  • 47. Income and Substitution Effects  Income Effect • Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.
  • 48. Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) F1 S C1 Originally, the consumer is at A on budget line RS. A U1
  • 49. Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 When the price of food falls, consumption increases by F1Fs as the consumer moves to B. U2 B
  • 50. Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 U2 B E Total Effect Substitution Effect The substitution effect,F1E, (from points AD), changes the relative prices but keeps real income constant. D
  • 51. Income and Substitution Effects-- Normal Good Food (units per month) O R Clothing (units per month) C2 F1 S F2 T C1 A U1 The income effect, EF2, (D to B) keeps relative prices constant but increases purchasing power. U2 B E Total Effect Substitution Effect Income Effect D
  • 52. Income and Substitution Effects-- Inferior Good Food (units per month) O R Clothing (units per month) F1 S Originally, the consumer is at A on budget line RS. A U1
  • 53. Income and Substitution Effects-- Inferior Good Food (units per month) O R Clothing (units per month) F1 S T A U1 E Substitution Effect The substitution effect,F1E, (from points AD), changes the relative prices but keeps real income constant. D
  • 54. Income and Substitution Effects-- Inferior Good Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect. Total Effect Food (units per month) O R Clothing (units per month) F1 S F2 T A U1 E Substitution Effect D B Income Effect U2
  • 55. Income and Substitution Effects  A Special Case--The Giffen Good • The income effect may theoretically be large enough to cause the demand curve for a good to slope upward. • This rarely occurs and is of little practical interest.
  • 56. Market Demand  From Individual to Market Demand • Market demand curves are the horizontal summation of the individuals’ demand curves.
  • 57. Determining the Market Demand Curve 1 6 10 16 32 2 4 8 13 25 3 2 6 10 18 4 0 4 7 11 5 0 2 4 6 Price Individual A Individual B Individual C Market ($) (units) (units) (units) (units)
  • 58. Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A The market demand curve is obtained by summing the consumer’s demand curves
  • 59. Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A DB The market demand curve is obtained by summing the consumer’s demand curves
  • 60. Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A DB D C The market demand curve is obtained by summing the consumer’s demand curves
  • 61. Summing to Obtain a Market Demand Curve Quantity 1 2 3 4 Price 0 5 5 10 15 20 25 30 D A DB D C Market Demand The market demand curve is obtained by summing the consumer’s demand curves
  • 62. Market Demand  Two Important Points 1) The market demand will shift to the right as more consumers enter the market. 2) Factors that influence the demands of many consumers will also affect the market demand.
  • 63. Market Demand  Point and Arc Elasticities of Demand • Recall: Price elasticity of demand measures the percentage change in the quantity demanded resulting from a percentage change in price. P Q P Q P/P Q/Q EP / /      
  • 64. Price Elasticity and Consumer Expenditure If Price Increases, If Price Decreases, Demand Expenditures Expenditures Inelastic (Ep<1) Increase Decrease Unit elastic (Ep=1) Are unchanged Are unchanged Elastic (Ep>1) Decrease Increase
  • 65. Market Demand  Point and Arc Elasticities of Demand • For large price changes (e.g. 20%), the value of elasticity will depend upon where the price and quantity lie on the demand curve.
  • 66. Market Demand  Point and Arc Elasticities of Demand • Point elasticity measures elasticity at a point on the demand curve. • Its formula is: ope) (P/Q)(1/sl EP 
  • 67. Market Demand  Problems Using Point Elasticity • We may need to calculate elasticity between two points instead of at a single point. • The price and quantity used as the original will alter the price elasticity of demand. • Using different original values will result in different calculations.
  • 68. Market Demand  Point and Arc Elasticities of Demand • Arc Elasticity: Arc elasticity uses the average of the initial and final price as the original. • Its formula is: ) /Q P P)( Q/ ( EP   
  • 69. Example:The Aggregate Demand For Wheat  The demand for U.S. wheat is comprised of domestic demand and export demand.
  • 70. Example:The Aggregate Demand For Wheat  The domestic demand for wheat is given by the equation: • QDD = 1354 - 70P  The export demand for wheat is given by the equation: • QDE = 2031 - 209P
  • 71. Example:The Aggregate Demand For Wheat  Domestic demand is relatively price inelastic (-0.2), while export demand is more price elastic (-0.4 to -0.5).
  • 72. The Aggregate Demand for Wheat Quantity (millions of bushels per year) Price ($/bushel) 0 2 4 6 8 10 12 14 16 18 20 1000 2000 3000 4000 A C B D Domestic Demand Export Demand
  • 73. The Aggregate Demand for Wheat Quantity (millions of bushels per year) Price ($/bushel) 0 2 4 6 8 10 12 14 16 18 20 1000 2000 3000 4000 A C B D Domestic Demand Export Demand E F Total Demand Total world demand is the horizontal sum of the domestic demand AB and export demand CD.
  • 74. Consumer Surplus  Consumer surplus is the difference between what a consumer is willing to pay for a good and what the consumer actually pays when buying it.
  • 75. Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20
  • 76. Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. Market Price
  • 77. Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 Market Price Consumer Surplus The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually.
  • 78. Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 The consumer’s actual expenditure is the price times the quantity purchased. Market Price Actual Expenditure Consumer Surplus
  • 79. Consumer Surplus  The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller.
  • 80. Consumer Surplus Rock Concert Tickets Price ($ per ticket) 2 3 4 5 6 13 0 1 14 15 16 17 18 19 20 For goods that cannot be divided into small parts the consumer surplus is the yellow area below the demand curve. Actual Expenditure Demand Curve Market Price Consumer Surplus
  • 81. Consumer Surplus  Consumer surplus along with aggregate profits allow us to evaluate: 1) Costs and benefits of different market structures 2) Public policies that alter the behavior of consumers and firms
  • 82. Example: The Value of Clean Air  Air is free in the sense that we need not pay to breathe it.  The Clean Air Act was amended in 1970.  Question: Were the benefits of cleaning up the air worth the costs?
  • 83. Example: The Value of Clean Air  People pay more to buy houses where the air is clean.  Data for house prices among neighborhoods of Boston and Los Angeles were compared with the various air pollutants.
  • 84. Valuing Clean Air NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 0 1000 2000 5 10
  • 85. Valuing Clean Air NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 0 1000 2000 5 10
  • 86. Valuing Clean Air NOX (pphm) Pollution Reduction Value ($ per pphm of reduction) 0 1000 2000 5 10 A The shaded area gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrous oxide at a cost of $1000 per part reduced.

Editor's Notes