Individual & Market Individual & Market DemandDemand

Chapter 4Chapter 4

4 main topics related to Individual & Market Demand

1. Use the Rational Choice model

Derive an individual’s demand curve

Construct a relationship that summarizes how individual demands vary with income

Individual & Market Demand

2. The total effects of a price change can be broken down into two effects:

1. Substitution Effect

2. Income Effect

Individual & Market Demand

3. Individual demand curves can be added to yield the demand curve for the whole market

Individual & Market Demand

4. Price elasticity of demand is a responsiveness measure for changes in price

Income elasticity of demand measures the individual’s purchase responsiveness to small changes in income

Individual & Market Demand

Cross-elasticity of demand measures the responsiveness of the quantity demanded of one good to the small price changes of another

Effects of Changes in Price: Price-Consumption Curve (PCC)

Holding money, income and the prices of all other goods constant, the PCC of good X is the set of optimal bundles traced on an indifference map as the price of X varies

The Individual Consumer’s Demand Curve

The PCC contains all the information needed to construct an individual demand curve

Effects of Changes in Income: The Income-Consumption Curve (ICC)

Holding the prices of all goods constant, the ICC is the set of optimal bundles traced on an indifference map as money income varies

The Engel Curve

A curve that plots the relationship between the quantity of a good consumed and income

Normal & Inferior Goods

Normal goods have an upward sloping demand curve

For inferior goods, an increase in income leads to a reduction in quantity demanded

Substitution Effects of a Price Change

Component of the total effect

Results from the associated change in the relative attractiveness of other goods

Income Effect of a Price Change

Results from the associated change in real purchasing power

The total effect of a price change is the sum of the income and substitution effects

Market Demand

Aggregating individual demand curves

The horizontal sum of individual demand curves.

Price Elasticity of Demand

The percentage change in the quantity of a good demanded that results from a 1% change in its price

Price Elasticity of Demand

If the price elasticity is less than -1, demand is said to be elastic

If the price elasticity is between -1 and zero the good is inelastic

If the price elasticity is equal to -1 the good is unit elastic

Price Elasticity of Demand: Three Properties

Price elasticity is different at each point along a linear demand curve

Price Elasticity of Demand

Perfectly elastic demand has infinitely high price elasticity at all points

Perfectly inelastic demand is vertical, meaning that price elasticity is equal to zero at all points

Elasticity & Total Expenditure

“If the price of a product changes, how will the total amount spent on the product be affected?”

“Will more be spent on the product if we sell more units at a lower price or fewer units at a higher price?”

Determinants of Price Elasticity of Demand

Substitution Possibilities

Budget Share

Direction of Income effect

Time

The Dependence of Market Demand on Income

Government policies that redistribute income from the rich to the poor:

Increases demand for goods like food

Decreases demand for luxury items like jewellery

The Dependence of Market Demand on Income

Engel curves, at the market level, relate the quantity demanded to the average income level in the market

Income Elasticity of Demand

A formal measure of the responsiveness of purchase decisions to variations in the average market income

If a good has a stable Engel curve we can define its income elasticity of demand

Income Elasticity of Demand

Income elasticities for necessities must take on a value of ε<1

Luxuries are those goods for which ε >1

Cross-Price Elasticity of Demand

The percentage change in the quantity demanded of one good that results from a 1% change in the price of another good