4. Individual and Market Demand

Transcription

1 4. Individual and Market Demand Literature: Pindyck und Rubinfeld, Chapter 4 Varian, Chapter 6, Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 1

2 Chapter outline 1. Individual Demand 2. Income and Substitution Effects 3. Market Demand 4. Consumer Surplus 5. Empirical Estimation of Demand Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 2

3 Individual Demand Price Changes With the help of the illustrations developed in the previous chapter, the effects of a change in the price of food can be illustrated by using indifference curves Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 3

4 Effects of Price Changes Clothing (units per month) 10 Assume: I = 20 P C = 2 P F = 2, 1, A U 1 B D Three separate indifference curves touching their respective budget lines. U 3 U Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 4

5 Effects of Price Changes Clothing (units per month) Price-consumption curve: a curve tracing the utility-maximizing combinations of two goods as the price of one changes (in this case food). 6 A Price-Consumption Curve 5 U 1 B D 4 U 3 U Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 5

6 Effects of Price Changes Price of Food 2.00 E Individual demand curve: a curve relating the quantity of a good-that a single consumer will buy-to its price G Demand Curve H Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 6

7 Individual Demand The individual demand curve has two important properties: 1) The level of utility that can be attained changes as we move along the curve. 2) At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the marginal rate of substitution (MRS) of food for clothing equals the price ratio of food and clothing Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 7

8 Effects of Price Changes Food Price 2.00 If price falls, then P f /P c & MRS decrease as well. E G Demand Curve H E: P f /P c = 2/2 = 1 = MRS G: P f /P c = 1/2 = 0.5 = MRS H:P f /P c = 5/2 = 0.25 = MRS Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 8

9 Individual Demand Income Changes Taking our example on food and clothing, the effects of a change in income can be illustrated using indifference curves Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 9

10 Effect of Income Change Clothing (units per month) Assume: P f = 1 P c = 2 I = 10, 20, A U 1 B U 2 D U 3 Income-Consumption Curve A change in income, with prices of all goods fixed, causes consumers to alter their choice of market baskets Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 10

11 Effect of Income Change Foodprice An increase in income from 10 to 20 and 20 to 30, with the prices for all goods fixed, shifts the demand curve to the right E G H D 3 D D 1 Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 11

12 Individual Demand Change in income: Income consumption curve: Curve tracing the utilitymaximizing combinations of two goods as a consumer s income changes. An increase in income causes a rightward shift in the budget line. This leads to having higher consumption along the income consumption curve. At the same time, due to the increase in income, the demand curve shifts to the right Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 12

13 Individual Demand Normal versus Inferior Goods Changes in income if the Income-consumption curve has a positive slope, then demand decreases as income increases; income elasticity of demand is positive, and the good is a normal Good Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 13

14 Individual Demand Normal versus Inferior Goods Changes in income if the Income-consumption curve has a negative slope, then demand decreases with increasing income; income elasticity of demand is negative, and the good is an inferior Good Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 14

15 Inferior Good Steaks 15 (units per month) 10 Income-Consumption Curve C Here, hamburger and steaks are normal goods between points A and B U 3 5 B but hamburgers become an inferior good when the income-consumption curve bends backwards between points B and C. A U 2 U Hamburgers (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 15

16 Individual Demand Engel curves Curve relating the quantity of a 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 negatively sloped Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 16

17 Engel Curves Income ( per month) With a normal good, the Engel curve is positively sloped Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide Food (units per month)

18 Engel curves Income ( per month) With inferior goods, the Engel curve is negatively sloped. inferior 10 normal Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 18

19 Individual Demand Substitutes and Complements 1) Two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other. For example: cinema tickets and movie rentals. 2) Two goods are complements if an increase in the price of one good leads to a decrease in the quantity demanded of the other. For example: gasoline and motor oil Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 19

20 Individual Demand Substitutes and Complements 3) Two goods are independent if a change in the price of one good has no effect on the quantity demanded of the other. Substitutes and Complements If the price-consumption curve is negatively sloped then we consider the goods to be substitutes. However, if the price consumption curve is positively sloped then we consider the goods to be complements Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 20

21 Income and Substitution Effects A fall in the price of a good has two effects: the substitution & the income effect. 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. This response to a change in the relative prices of goods is called the substitution effect. 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. The change in demand resulting from this change in real purchasing power is called the income effect Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 21

22 Income and Substitution Effects Substitution effect Change in consumption of a good associated with a change in its price, with the level of utility held constant. If the price of the good decreases, the substitution effect leads to increased demand for this good Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 22

23 Income and Substitution Effect Income effect: Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant. If the income of the individual increases, this causes the demanded quantity to either increase or decrease. Even when we have inferior goods, the income effect is rarely large enough to compensate for the substitution effect Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 23

24 Income and Substitution Effects: Normal Goods Clothing (units per month) R C 1 When the price of food falls, consumption increases by F 1 F 2, as the consumer moves from A to B. The substitution effect F 1 E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. A C 2 D B The income effect EF 2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Substitution effect U 1 U 2 O F 1 Total effect E S F 2 Income effect T Food (units per month) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 24

25 Income and Substitution Effect: Inferior Goods Clothing (units per month) R A B In this case, food is an inferior good because the income effect is negative. However, because the substitution effect exceeds the income effect, the decrease in the price of food leads to an increase in the quantity of food demanded D U 2 O Substitutioneffect F 1 E S F 2 T Food Total effect (units per month) Income effect U Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 25

26 Income and Substitution Effect: A Special Case - the Giffen Good Theoretically, the income effect can be so large that the demand curve of a good is positively sloped. This rarely occurs and is of little practical interest Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 26

27 The Effects of a Gasoline Tax Assume: The taxes on gasoline are 0.5 Income = 9,000 Price of gasoline = 1 Elasticity of demand = -0.5 Income elasticity = 0.3 Demand without tax 1200l We will see that the tax makes the consumer worse off even when the consumer gets a tax rebate Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 27

28 The Effect of a Gasoline Tax with a Tax Rebate. Expenditure on other goods( ) F A After Gasoline Tax plus Rebate 0.50 consumer taxes Gasoline = 900 Liter After Gasoline Tax E H C 450 Tax Rebate New budget line Consumer worse off U 2 Gasoline = 1200 Liter Other expenses= 7,800 U 3 U 1 Original Budget Line D J B Gasoline consumption (gallons per year) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 28

29 As for other goods and services, the prices of gasoline and diesel are freely formed on the basis of supply and demand. As regular investigations show, the prices for petrol and diesel at the petrol stations in Germany are fundamentally in line with the wholesale prices for fuels on the Rotterdam petroleum market. These, in turn, usually follow the crude oil price, but may, depending on the supply and demand of the product in question, detach to some extent from the crude oil price in the short term. In addition to the price for the respective product, further cost items are also included in the final consumer prices. These include the energy tax, which has been cents per liter for diesel and cents per liter for petrol and the value added tax 19 percent of the total value of the goods (including energy tax). (BMWi ) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 29

30 Market Demand From Individual to Market Demand Market Demand Curve Curve relating the quantity of a good, that all consumers in a market will buy, to its price Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 30

31 Determining the Market Demand Curve Price Person A Person B Person C Market ( ) (units) (units) (units) (units) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 31

32 Summing to Obtain a Market Demand Curve Price 5 4 The market demand curve is obtained by summing our three consumer demand curves D A, D B, and D C. 3 2 Market Demand 1 D A D B D C Quantity Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 32

33 Market Demand Two points should be noted: 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. The aggregation of individual demands into a market demand becomes important in practice when market demands are built up from the demands of different demographic groups or from consumers located in different areas Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 33

34 Market Demand Elasticity of Demand Remember that the price elasticity of demand measures the percentage change in the demanded quantity resulting from a one percent change in the price: EP Q / Q Q / P Q P P / P Q / P P Q Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 34

35 Price Elasticity and Consumer Expenditures Demand If price increases, If price decreases, expenditures expenditures Inelastic (E p <1) Increase Decrease Unit elastic (E p = 1) Are unchanged Are unchanged Elastic (E p >1) Decrease Increase Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 35

36 Point Elasticities Point elasticity of demand For significant price changes (e.g., 20%), the elasticity value depends on the pount at which we measure price and the quantity along the demand curve. Point elasticity of demand Price elasticity at a particular point on the demand curve. Point elasticity: E P (P / Q)(1 / Slope) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 36

37 Point Elasticities Issues when using point elasticity: We may need to calculate the price elasticity over a certain range of points on the demand curve and not only at a single point. The price and quantity used for calculating the elasticity affects the price elasticity of demand Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 37

38 Point Elasticities Point elasticity of demand (example) Assume: The price increases from 8 to 10, and the quantity demanded decreases from 6 to 4. Is the percentage change in price 2/ 8 = 25% or 2/ 10 = 20% Is the percentage change in quantity -2/6 = % or -2/4 = -50% Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 38

39 Point Elasticities Point elasticity of demand (Example) The elasticity is equal to /25 = or rather -50/20 = -2.5 Which one is correct? Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 39

40 Arc Elasticities Arc elasticity of demand Price elasticity calculated over a range of prices. The formula for the arc elasticity: EP ( Q / P)( P / Q) P average price Q average quantity Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 40

41 Market Demand Arc elasticity of demand (example) E ( Q / P)( P / Q) P 10 8 P1 8 P2 10 P Q1 6 Q2 4 Q 5 2 E ( 2 / 2)( 9 / 5) 1,8. P Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 41

42 The aggregated Demand for Wheat The total world demand for US wheat is the sum of the domestic demand and the export demand. Domestic demand for wheat is given by the equation Q DD = P Export demand for wheat is given by Q DE = P The domestic demand is relatively price inelastic (-0.2), the export demand is more price elastic (-0.4) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 42

43 The Aggregate Demand for Wheat Price ($/bushel) A C Export Demand E D The total world demand for wheat is the horizontal sum of the domestic demand AB and the export demand CD. Domestic Demand B Total Demand Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 43 F Wheat (millions of bushels/yr)

44 Consumer Surplus Consumer Surplus: Difference between what a consumer is willing to pay for a good and the amount actually paid Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 44

45 Consumer Surplus Price ( per ticket) The consumer surplus associated with purchasing six concert tickets (at $14 per ticket) is given by the yellow-shaded area: = Consumer surplus = 21 Market price Rock concert tickets Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 45

46 Consumer Surplus Price ( per ticket) The staircase shaped demand curve can be converted into a straight demand curve by a reduction in the units of the goods. Consumer Surplus 1/2x(20 14)x6.500 Actual Expenditure Consumer surplus in the market Market price Demand curve Rock concert tickets (thousand) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 46

47 Consumer Surplus When we combine consumer surplus with the aggregate profits that producers obtain, we can 1) evaluate both the costs and benefits of alternative market structures 2) and public policies that alter the behavior of consumers and firms in those markets Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 47

48 The Value of Clean Air Although there is no actual market for clean air, people do pay more for houses where the air is clean than for comparable houses in areas with more smog. Question: Are the benefits of clear air worth the costs? Example: Nitrogen oxides and diesel cars Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 48

49 Another Example: Noise Pollution and the A46 Consumers pay more for houses located in quiet areas. Data on real estate prices in Wuppertal can be compared while taking the degree of street-traffic noise into account. Using the data on real estate prices in Wuppertal we can check the effect of noise on house prices Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 49

50 Assessment of Noise Reduction (Plausibility Check!!!!!) Value ( per decibel) 2000 The shaded triangle is the consumer surplus when noise pollution at a price of 1,000 per reduced db is reduced by 20 dbs to 60 dbs A Decibel Reduction Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 50

51 Empirical Estimation of Demand The most direct method to determine information about demand, is to conduct interviews in which consumers are asked what quantity of a product they are willing to buy at a certain price. Problem: Consumers may be lacking information, interest, or may even want to mislead the interviewer Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 51

52 Empirical Estimation of Demand In direct marketing experiments, actual sales offers are posed to potential customers and customer s responses are monitored. The statistical approach to estimate demand. Properly applied, the statistical approach to estimating demand can enable us to determine the effects of variables on the demanded quantity of a product. The "least squares" regression method is such an approach Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 52

53 Data on the Demand of Raspberries Year Quantity (Q) Price (P) Income (I) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 53

54 Empirical Estimation of Demand Assume price is the only determinant for demand: Q = a - bp Q = P Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 54

55 Estimating Demand Price D is the demand curve, when only price P determines the demand; from the data we know that Q = P d d 2 D d Quantity Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 55

56 Estimating Demand Price Adjustments to income changes d 1, d 2, and d 3 are the demand curves for each income level. By substituting income in the demand equation we get Q = a bp + ci or Q = P I 15 d d 2 D d Quantity Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 56

57 Empirical Estimation of Demand Estimation of the Elasticities For the demand equation: Q = a bp Elasticity: E P ( Q / P)( P / Q) b( P / Q) Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 57

58 Empirical Estimation of Demand Estimation of the Elasticities Assume that price & income elasticity are constant. Isoelastic demand curve is log( Q) a blog( P) clog( I) Slope b = Price elasticity of demand Constant c = Income elasticity Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 58

59 Empirical Estimation of Demand Estimation of the Elasticities Using the data on raspberries log( Q) log( P) 1.32log( I) Price elasticity = (inelastic) Income elasticity = Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 59

60 Empirical Estimation of Demand Estimation with substitutes and complements log( Q) a blog( P) b log P clog( I) 2 2 Substitutes: b 2 is positive. Complements: b 2 is negative Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 60

61 Concluding Remarks The demand curves of individual consumers for a product can be derived from information available about their preferences for goods and services as well as their budget constraints. Engel curves describe the relationship between the consumed quantity of a good and the income Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 61

62 Concluding Remarks Two goods are substitute goods (complements) when an increase in the price of one good leads to an increase (decrease) in the quantity demanded of the other good. The effects of a price change on the demanded quantity can be divided into a substitution effect and an income effect Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 62

63 Concluding Remarks The market demand curve is the horizontal addition of individual demand curves for all consumers. The percentage change in the demanded quantity resulting from a one percent change in the price determines the elasticity of demand. A number of methods can be used to determine information about consumer demand Prof. Dr. Kerstin Schneider Chair of Public Finance and Business Taxation Microeconomics Slide 63