microéconomie, chapter 4cermsem.univ-paris1.fr/davila/teaching/sbs/ch04_pindyck...31 solvay...

1 Solvay Business School – Université Libre de Bruxelles

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Individual and market demand

Microéconomie, chapter 4


2

Plan of the talk

 Individual demand

 Income effect and substitution effect

 Market demand

 Consumer’s surplus

 Network externalities

 Empirical estimation of demand


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Individual demand

Changes in prices:  The effect of a change in prices can be seen

with the help pf the indifference curves  For any given price, the individual demand

for each good is determined by his indifference curves and the budget line


4

Impact of changes in prices

For each price, a different quantity of food is demanded 5

U3

D

4

U2

B

12 20

assume: •  R = €20 •  Pc = €2 •  Pf = €2, €1, €0,50

food

clothes

6 A

U1

4

10

40 10


5


The price-consumption curve is drawn by the consumer’s choice as the price of the good changes

4

U2

B

12 20

5

U3

D

food

clothes

6 A

U1

4

10

Price-consumption curve


6


  The change of the consumer’s choice as the price of a good changes gives the consumer’s individual demand

  In the previous example:

Demand curve

P Q

€2,00 4

€1,00 12

€0,50 20


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Individual demand curve

The individual demand curve gives the quantity he wants to buy at each price

food

Price of food

H

E

G

€2,00

4 12 20

€1,00

€0,50


8

Individual demand curve: important properties

 Utiltiy changes along the demand curve  At each point on the curve the consumer

maximizes his utility making equal the MRS of food to clothes and the relative price of food in terms of clothes


9


food

Price of food

H

E

G

€2,00

4 12 20

€1,00

€0,50 Individual demand curve

•  E: Pf /Pc = 2/2 = 1 = MRS •  G: Pf /Pc = 1/2 = 0,5 = MRS •  H: Pf /Pc = 0,5/2 = 0,25 = MRS

As the price decreases, Pf /Pc and MRS decrease also


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Individual demand

 Changes in income  The impact of changes in income can be

seen with the help of the indifference curves  A change in income, at constant prices,

changes the consumer’s choice


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Impact of changes in income

food

clothes

For each level of income, a different bundle of goods is purchased

3

4

A U1

5

10

B U2

D 7

16

U3

Assume: • Pf = €1 • Pc = €2 •  I = €10, €20, €30

20 30


12


food

clothes The income expansion path is drawn by the consumer’s

choice as his income changes

3

4

A U1

5

10

B U2

D 7

16

U3

Income expansion path

20 30


13


food

Price of food An increase in income from €10 to €20 and to €30, at constant prices, shifts in general the individual demand curve outwards

€1,00

4

D1

E

10

D2

G

16

D3

H


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Individual demand

 Changes in income  When the income-expansion path is

positively sloped:  Demand increases as income increases  The income-elasticty of the demand is positive  The good is a normal good


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Individual demand

 Changes in income  When the income-consumption path is

negative:  Demand decreases as income increases  The income-elasticty of the demand is negative  The good is an inferior good


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Inferior goods

potatoes

meat

30

U3

C

Income expansion path

…but potatoes become an inferior good between

B and C

10 5

A U1

5

20

10

B

U2

Meat and potatoes behave as normal goods between

A and B...


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Individual demand

 Engel curve  The Engel curve gives for each level of

income the quantity of the good demanded  For a normal good the Engel curve is

increasing  For an inferior good the Engel curve is

decreasing


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Engel curve

food

30

10

income

20

4 8 12 16

For normal goods the Engel curve is

increasing


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Engel curve

For inferior goods the Engel curve bends

backwards

inferior

normal

food

30

10

income

20

4 8 12 16


20

Household spending


21

Substitutes and complements

 Two goods as substitutes if an increase (decrease) of one good’s pice increases (decreases) the demand for the other good  Ex: movie theater tickets and DVD rental

rates


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 Two goods are complements if an increase (decrease) of one good’s price can decrease (increase) the other goods demand  E.g. gas and motor oil


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 Two goods are independent if changes in the price of one of them has no impact on the demand for the other good  E.g. price of rice and air fares


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 If the price-consumption curve is decreasing, the two goods are substitutes

 If the price-consumption curve is increasing, the two goods are complements

 Two goods can be substitutes and complements at different ranges of prices


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Income effect and substitution effect

 Changes in prices have two effects:  A substitution effect  An income effect


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Income effect and substitution effects

 Substitution effect  Changes in a monetary price varies the

relative price  The consumer will tend to increase his

demand for the relatively cheaper good and decrease that of the relatively more expensive good


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Income effect and substitution effects

 Income effect  A decrease of a price increases the

consumer’s purchasing power


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 Substitution effect  Change in the demand due to the change in

the relative price, i.e. keeping utilitiy constant  A decrease in a price induces always a

substitution effect that tends to increase the demand for the good


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 Income effect  Change in demand due to the change in the

purchasing power, i.e. keeping the relative price constant

 When the consumer’s income his demand for a good may increase or decrease


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 Income effect  For inferior goods, he income and

substitution effect go in opposite directions, but usually the substitution effect dominates


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Income and substitution effects: normal goods

food O

clothes

R

F1 S

C1 A

U1

Income effect from D to B: leaves the relative price unchanged but changes the purchasing power

Income effect

C2

F2 T

U2

B

As the price of food decreases, demand increases from F1 to F2

E Total effect

Substitution effect

D

Substitution effect from A to D: changes the relative price but leaves utility unchanged


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food O

R

clothes

F1 S F2 T

A

U1

E

Substitution effect

D

Total effect

Since food is an inferior good, the income effect

is negative. The substitution effect domintes nonetheless

B

Income effect

U2

Income and substitution effects: normal goods


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Income and substitution effects

 A special case: Giffen goods  In principle the income effect can be opposite

to the substitution effect and strong enough to dominate it so that the demand curve becomes increasing

 This happens very rarely


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Market demand

 Market demand curve  Gives for each price the aggregate demand

of all consumers for a good  It is the horizontal sum of all the individual

demand curves


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Market demand curve

price A B C Market demand

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


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Market demand curve

quantity

1

2

3

4

price

0

5

5 10 15 20 25 30

DB DC

Market demand

DA

The market demand curve is the horizontal sum

of all the individual demand curves


37

Market demand

 Price-elasticity of the demand  The rate of change of demand with respect

to a change in the price, in percentage terms


38

Market demand



€

EP = %ΔQ%ΔP

=dQ/QdP/P

=dQdP

PQ


39

Market demand



€

EP = %ΔQ%ΔP

=dQ/QdP/P

=d(lnQ)d(lnP)


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Price-elasticity of the demand

 Inelastic demand  Ep is smaller than1 in absolute value  Demand is relatively insensitive to changes

in the price  |%ΔQ| < |%ΔP|  Total spending (PxQ) increases as the price

increases


41


 Elastic demand  Ep is bigger than 1 in absolute value  Demand is relatively very sensitive to

changes in the price  |%ΔQ| > |%ΔP|  Total spending (PxQ) decreases as the price

increases


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demand As price increases, spending…

As price decreases, spending…

inelastic increases decreases

unit elastic doesn’t change doesn’t change

elastic decreases increases


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 Isoelastic demand  Price-elasticity is constant along the demand

curve  The demand curve is convex towards the

origin (it cannot be linear)


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Total spending remains constant under an isoelastic demand: P1 x Q1 = P2 x Q2 = P3 x Q3

food

Price of food

P1

Q1

P2

Q2

P3

Q3



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For a linear demand, total spending first increases and then decreases as the price increases: P1 x Q1 < P2 x Q2 > P3 x Q3

food

Price of food

P1

Q1

P2

Q2

P3

Q3

Price-elasticity of demand


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Example: wheat aggregate demand

 The demand for wheat has two parts:  Domestic demand  Exports demand

 Total demand is obtained aggregating these two components


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 Domestic demand is relatively inelastic (e.g. Ed = -0.2)

 Export demand is relatively elastic (e.g. Ed = -0.4)  Importing countries can switch to other

cereals if the price of wheat increases


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C

D

Exports demand

Total demand is the horizontal sum of domestic demand AB

and exports demand CD

F

Total demand

A

B

Domestic demand

E


wheat

price

0

10

16

18

Above C, export demand vanishes, so domestic demand = total demand = segment AE


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Consumer’s surplus

 Consumers buy goods in order to improve their well-being

 The consumer’s surplus measures this improvement


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 consumer’s surplus  The difference between what he is willing to

pay for a good and what he actually pays  It can be computed using the demand curve


51

The consumer’s surplus: Example

 The individual demand curve expresses what the consumer is willing to pay for each unit of the good  If for a price €20 he demands 1 unit, then he

is willing to pay for €20 this first unit  If he gets this first unit for €14 then he

obtains a surplus of €6  This computation can be made for each unit

purchased  The consumer’s surplus is the sum of all the

surpluses obtained from all units purchased


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The surplus from buying 6 units is the sum

of the surpluses obtained from buying each of them

Total surplus 6 + 5 + 4 + 3 + 2 + 1 = 21

Consumer’s surplus: Example

units

price

2 3 4 5 6

13

0 1

14 15 16 17 18 19 20

Market price

A 7th unit is not worth buying since its surplus is negative


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 The stepwise demand curve can be smoothed using small enough units of measure

 The consumer’s surplus is the area below the demand curve and above the market price


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Demand curve



units

price

2 3 4 5 6 0 1

Actual spending

14 15 16 17 18 19 20

Market price

CS = ½ (€20 - €14) x 6,5

= €19,5


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Use of consumer’s surplus

  Producer’s surplus and profits allow to assess:

1.  Pros and cons of different market structures 2.  Policies intended to modify the consumers’

and firms’ decisions


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Network externalities

 We have assumed implicitly that each consumer’s demand is independent of everybody else’s demand

 For some goods individual demands are interdependent


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 When individual demands are interdependent, there exist network externalities

 Network externalities can be positive or negative


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 A positive network externality exists when each individual demand increases whenever everybody else’s demand increases

 A negative network externality exists when each individual demand decreases whenever everybody else’s demand increases


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Positive network externality

quantity

price D20

20

As the number of consumers in a network increases, individual demands shift outwards

40

D40

60

D60

80

D80

100

D100


60


quantity

price D20

20

As a result of a positive network externality market demand becomes relatively more elastic

40

D40

60

D60

80

D80

100

D100

Demand


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quantity

price •  If the price decreases from €30 to €20, the price effect increases demand from 40 to 55 •  the positive network externality increses further the demand to 80

40

D40

60

D60

80

D80

100

D100

Demand

€30

D20

20 55

€20

Price effect

Positive externality


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Negative network externality

 snobism: consumers look for «exclusive goods»  The less a good is «popular», the more

some consumers will pay for it


63

Negative network externalities

quantity

price

2

Demand

D2

€30,000

€15,000

14

Initial demand D2

4 6 8

D4

D6 D8

As the good becomes popular demand shifts from D2 to D6


64

Empirical estimation of demand

 Statistical approach  It allows to measure the impact of prices and

income on demand  The most propular method is ordinary least

squares


65


quantity

price

0 5 10 15 20 25

15

10

5

25

20

D

D represents the demand if ony P determines the quantity demanded, so that by OLS: Q=26-1,25P


66


quantity

price

0 5 10 15 20 25

15

10

5

25

20

D

d1

d2 d3

d1, d2, d3 represent the demand at three different levels of income, i.e. if Q = a - bP + cR, so that Q = 8,08 – 0,4P + 0,81R


67


 Estimation of the elasticities  For the equation: Q = a - bP

€

EP =ΔQΔP

PQ

= −b PQ


68


 Estimation of the elasticities

 For the equation:

-b = price-elasticity c = income elasticity €

Q = a Rc

Pb


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 Substitutes: b2 positive  Complements: b2 négative


microéconomie, chapter 4cermsem.univ-paris1.fr/davila/teaching/sbs/ch04_pindyck...31 solvay...

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