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Consumer demand
From the optimal choice of a consumer to overall market
demand
Consumer demand
Up until now, we’ve examined how a single consumer chooses the best (most satisfying) bundle out of the set of affordable ones
The next step is to derive the demand function for each good: What amount of each good is chosen for each
level of its price? Then, we need to see how all the individual
demand functions add up to the market demand for that good
Consumer demand
Deriving consumer demand
From individual to market demand
Elasticities
Deriving consumer demand
As we have seen, given a stable set of preferences, the amount of a good chosen in a bundle depends on : The price of the good The price of other goods The income of the agent
The quantity demanded by the ith agent is therefore a function of these three variables 1 1, ,i i
othersx f p p I
Deriving consumer demand
The effects of a change of income on demand:
The demand for normal goods increases when income increases
Some goods are inferior : The demand for these goods decreases when income increases
If one plots all the quantities demanded for each level of income, one gets the Engel curve
Deriving consumer demand
Good 1
Good 2
A
B
C
Income expansion path
Deriving consumer demand
Other goods
DVD
Demand for DVDs
Income
E2
E3
100E’1
50E’2
150E’3
E1
Engel curve
Deriving consumer demand
Income
Demand
Income
Demand
Engel curves
Normal good Inferior good
Deriving consumer demand
The effects of a change of price on demand
Generally, because of the substitution effect, the demand for a good varies inversely with its price
Some goods are Giffen goods : The demand for these goods varies in the same direction as price (income effect)
If one plots all the quantities demanded for each level of price, one gets the Demand curve
Deriving consumer demand
Good 1
Good 2
B
A
C
Price expansion path
Deriving consumer demand
Other goods
DVD
Demand for DVDs
Price of DVDs
E2
E3
20 E’1
40 E’2
10E’3
E1
Demand curve
Deriving consumer demand
Price1
Demandof agent i
A typical demand curve:
1 1, ,i iothersx p p I
1ix
1p
1ix
1p
If the price falls, the individual demands more of the good
Deriving consumer demand
IMPORTANT NOTE: The demand function depends on
The price of the good The price of other goods The income of the agent
The demand curve only shows a relation between demand and the price of the good So how do the other variables (income, the
price of other goods) affect the demand curve?
1 1, ,i iothersx p p I
Deriving consumer demand
Price1
Demandof agent i
The effect of income changes on the demand curve
1 1, ,i iothersx p p I
1ix
1p
If the income increases, the demand increases (at constant price)
If the income falls, the demand falls (at constant price)
Deriving consumer demand
Price1
Demandof agent i
1 1, ,i iothersx p p I
1ix
1p
The effect of a change in another price on the demand curve...
It depends on the relative size of the income and substitution effects (Of opposite directions here)This in turn depends on whether the 2 goods are substitutes or complements
... is ambiguous !!
Consumer demand
Deriving consumer demand
From individual to market demand
Elasticities
From individual to market demand
Market demand is the aggregate quantity demanded at a given price level
It is not the demand of a single individual, but that of all the agents in the economy
The market demand for a good depends on the relative price of that good and the distribution of all the incomes in the economy
1 21 1 1 1
1
, , , , , , ,i n
n i iothers others
i
X p p I I I x p p I
From individual to market demand
Price
Agent 1’s demand
Agent 2’s demand
Market demand
1x 2x X
A simple 2-agent example
From individual to market demand
Price1
Market Demand
A Market demand curve
1 21 1, , , , , n
othersX p p I I I
1X
1p
1X
1p
If the price falls, the market demand for the good increases
Consumer demand
Deriving consumer demand
From individual to market demand
Elasticities
Elasticities
The concept of an elasticity is central to microeconomic theory :
Up until now, we have reasoned in qualitative terms. A demand curve is downward sloping It moves upwards if income increases
If we want our theory to be useful in the real world, we need to quantify these concepts. How sensitive is demand to price /Income ? Is this the same for all goods ?
Elasticities
An elasticity is a measure of this sensitivity It gives the % change in one variable following a
% change in another variable
Example : The price elasticity of demand
A price elasticity of demand of -0.5: An increase in price of 1 % ⇒ fall in demand of 0.5 % An increase in price of 10 % ⇒ fall in demand of 5 %
%
%dD
p
Q
p
Elasticities
The percentage change of a function is defined as:
This means that we can express the elasticity as:
% dd
d
Q
%
%dD d
pd
Q Q p
p Q p
D dp
d
Q p
p Q
Slope of the demand function
Price/Demand ratio
Elasticities
Price
Quantity
Demand
p
Qd
D dp
d
Q p
p Q
Slope of the demand function
Price/Demand ratio
Price elasticity of a linear demand curve
∂p
∂Qd
Elasticities
The demand function has 3 variables:
We now have measure of sensitivity for all these variables:
The price of the good Price elasticity of demand (which you already know)
The price of other goods Cross price elasticity of demand
The income of the agent Income elasticity of demand
1 1, ,i iothersx p p I
Elasticities
The price elasticity of demand: Is negative in general
An increase in price reduces the quantity demanded Is positive for Giffen goods
Demand is price-elastic if the price elasticity is greater than 1 in magnitude 10 % increase in price ⇒ >10% fall in demand
Demand is price-inelastic if the price elasticity is smaller than 1 in magnitude 10 % increase in price ⇒ <10% fall in demand
Elasticities
The cross price elasticity of demand Measures the variation of the quantity
demanded following an increase in the price of another good
This gives information on whether the goods are substitutes or complements
Example : what is the effect of the increase in fuel prices on the demand for Hummers ??
Elasticities
The cross price elasticity of demand Is negative in for complement goods
Example : ↑ price of fuel ⇒ ↓ demand for cars Is positive for substitute goods
Example : ↑ price of coffee ⇒ ↑ demand for tea
The magnitude of the elasticity gives information on the strength of the link A large magnitude (>1) means a strong complement /
substitute link A small magnitude (<1) means a weak link A magnitude close to 0 means no link
Elasticities
The income elasticity of demand measures the variation of the quantity demanded
following an increase in income of agents
Is negative in for inferior goods An increase in income reduces the quantity demanded
Is positive for normal goods An increase in income increases the quantity demanded
Is greater than one for “luxury” goods An increase in income increases the quantity demanded
more than proportionately
