ECON-351: Chapter 6 Notes
ECON-351: Chapter 6 Notes Econ 351
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Date Created: 09/18/16
Chapter 6: Individual and Market Demand Sections: 6.1, 6.2, 6.3, 6.4, 6.5, 6.6 Section 6.1: Individual Demand Price Changes When the price of a good changes, the amount demanded does not change, but the quantity demanded/quantity consumed changes If the price increases, the QD decreases If the price decreases, the QD increases The Individual Demand Curve Price consumption curve: curve tracing the utility maximizing combinations of two goods as the price of one changes Individual demand curve: curve relating the quantity of a good that a single consumer will buy to its price; has two important properties: 1. The level of utility that can be attained changes as we move along the curve. The lower the price of the product, the higher the level of utility; higher indifference curve is reached as the price falls; as the price falls, the consumer’s purchasing power increases 2. At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS equals the ratio of prices Income Changes A change in income shifts the demand curve itself, not the quantity demanded An increase in income shifts the individual demand curve to the right, a decrease in income shifts the individual demand curve to the left Incomeconsumption curve: curve tracing the utility maximizing combinations of two goods as a consumer’s income changes An increase in income, with the price of all goods fixed, causes consumers to alter their choice of market baskets; the baskets that maximize the consumer satisfaction for various incomes trace out the incomeconsumption curve Normal vs. Inferior Goods Normal goods: consumers buy more of it as their income increases; buy less if income decreases Incomeconsumption curve has positive slope Quantity demanded increases with income Income elasticity of demand is positive The greater the shifts to the right of the demand curve, the larger income elasticity Inferior goods: consumers buy less of it as their income increases; buy more if income decreases Downward sloping income consumption curve Quantity demanded decreases with income Income elasticity of demand is negative Engel Curves Relate the quantity of a good consumed to an individual’s income An upward sloping Engel curve applies to all normal goods Sideways U shaped engel curve is for a good that: Begins as a normal good while income rises Becomes an inferior good when income rises to a greater level Upward sloping portion is when the good is normal Backwards sloping portion is when the good is inferior Substitutes and Complements Two goods are substitutes if the increase in price of one leads to increased quantity demanded of the other Two goods are complements if the increase in price of one leads to decreased quantity demanded of the other Two goods are independent if the change in price of one good has no effect on the quantity demanded of another Priceconsumption curve can show if two goods are complements or substitutes Upward sloping PCC means two goods are complements Downward sloping PCC means two goods are substitutes Section 6.2: Income and Substitution Effects A fall in the price of a good has two effects: 1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive (substitution effect) 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power (income effect) Both effects normally occur simultaneously Substitution Effect Drop in price → substitution effect = the change in food consumption associated with a change in the price of food, with the level of utility held constant Substitution is marked by a movement along an indifference curve Substitution effect can be obtained by drawing a budget line which is parallel to the new budget line, but which is tangent to the original indifference curve (holding level of satisfaction constant) Income Effect Drop in price → income effect = the change in food consumption brought about by the increase in purchasing power, with relative prices held constant Normal good: positive income effect; as income increases, consumers choose to buy more of it Inferior good: negative income effect; as income increases, consumer choose to buy less of it Income effect is rarely large enough to outweigh substitution effect Substitution effect > income effect A Special Case: The Giffen Good Giffen good: a good whose demand curve slopes upward because the negative income effect is larger than the substitution effect Substitution effect < income effect Section 6.3: Market Demand Market demand curve: curve relating to the quantity of a good that all consumers in a market will buy to its price From Individual to Market Demand In the graph, the market demand curve is the horizontal summation (quantity demanded) of the demands of each consumer 1. The market demand curve will shift to the right as more consumers enter the market 2. Factors that influence the demands of many consumers will also affect market demand Elasticity of Demand Price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1% increase in price Price elasticity of demand = E = ΔQ/Q = ( )( ΔQ ) P ΔP/P Q ΔP Inelastic demand: when E iP< 1 in absolute value; when price increases, total expenditure increases (expenditure not consumption) Elastic demand: when E isP 1 in absolute value; when price increases, total expenditure decreases (expenditure not consumption) Isoelastic demand: when E isPonstant all along the demand curve; special case when the demand curve is unitelastic a demand curve with a price elasticity always equal to 1 Demand If price increases, If price decreases, expenditures expenditures Inelastic Increase Decrease Unit elastic Are unchanged Are unchanged Elastic Decrease Increase Speculative Demand Demand driven not by the direct benefits one obtains from owning or consuming the good but instead by an expectation that the price of the good will increase Profit by buying the good then reselling it when the price is higher It is often little more than gambling Section 6.4: Consumer Surplus If consumers buy goods to be better off, consumer surplus shows us how much better off Individual consumer surplus: the difference between what a consumer is willing to pay for a good and the amount actually paid Aggregate consumer surplus is the summation of all individual consumer surpluses Consumer Surplus and Demand CS is easily calculated if you know the demand curve Consumer surplus is the area of the triangle created when a line is drawn through the market price; the area under the demand curve, above the price, and to the left of the intersection To find aggregate consumer surplus, we find the area of the triangle in the market demand curve Section 6.5: Network Externalities Network externality: situation in which each individual’s demand depends on the purchases of other individuals Positive Network Externality Bandwagon effect: positive network externality in which a consumer wishes to possess a good in part because others do Negative Network Externality Snob effect: negative network externality in which a consumer wishes to own an exclusive or unique good Section 6.6: Empirical Estimation of Demand The Statistical Approach to Demand Estimation Can help researchers sort out the effects of variables like income and price of other products If price alone is the determinant, then the equation for Q is d Q = a bP If income and price are both determinants, then the equation for Q is d Q = a bP + cI The Form of the Demand Relationship Bc the demand equations are linear, a change in price affects Q at a constad rate, but the E p (price elasticity of demand) is different for every point Elasticity increases in magnitude as price increases and Q falls d Interview and Experimentation Approaches to Demand Determination One way to obtain info about demand is through interviews Consumers are asked how much of a given product they would buy at one price People may lack info, or want to mislead interviewers, so this method is not as reliable In direct marketing experiments, actual sales offers are posed to potential customers Direct experiments are real, not hypothetical, but they too have problems (expensive, different responses, many factors might have changed)
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