Individual & Market Demand
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1 Individual & Market Demand Lesson 5 Ryan Safner 1 1 Department of Economics Hood College ECON Microeconomic Analysis Spring 2017 Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
2 Lesson Plan 1 Framework and Assumptions 2 Income Effects 3 Deriving Demand Curves Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
3 Consumer Behavior Now that we understand consumer choices, we can link them to changing conditions in markets to derive demand curves and changes in demand Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
4 Lesson Plan 1 Framework and Assumptions 2 Income Effects 3 Deriving Demand Curves Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
5 Income Effect The income effect is the change in optimal consumption bundle associated with a change in income (or purchasing power), holding relative prices constant Will higher income yield more consumption? It depends! For normal goods, higher income yields higher levels of consumption Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
6 Income Effect (Normal Good) Basketball Tickets Suppose both vacation trips and basketball tickets are normal goods Q B Q T U Trips Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
7 Income Effect (Normal Good) Basketball Tickets Suppose both vacation trips and basketball tickets are normal goods An increase in income increases the budget line, and increases consumption of both, to a higher indifference curve Q B Q B Q T Q T U U 2 Trips Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
8 Income Effect The income effect is the change in optimal consumption bundle associated with a change in income (or purchasing power), holding relative prices constant Will higher income yield more consumption? It depends! For inferior goods, higher income yields lower levels of consumption Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
9 Income Effect (Inferior Good) Steak Suppose ramen is an inferior good and steak is a normal good Q S Q R U 1 Ramen Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
10 Income Effect (Inferior Good) Steak Suppose ramen is an inferior good and steak is a normal good An increase in income increases the budget line, and reaches a higher indifference curve, with increased consumption of steak, but less ramen Q S Q S Q Q R R U 2 U 1 Ramen Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
11 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
12 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D The income effect is given by (the sign of) Q D I Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
13 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D The income effect is given by (the sign of) Q D I If E D,I is positive: Q D I > 0: A normal good, buy more units of the good when you have more income. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
14 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D The income effect is given by (the sign of) Q D I If E D,I is positive: Q D I > 0: A normal good, buy more units of the good when you have more income. If E D,I is negative: Q D I < 0: An inferior good, buy less units of the good when you have more income. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
15 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D If E D,I is positive: Q D I > 0: A normal good, buy more units of the good when you have more income. Two subtypes of normal goods: Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
16 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D The income effect is given by (the sign of) Q D I If E D,I is positive: Q D I > 0: A normal good, buy more units of the good when you have more income. Two subtypes of normal goods: Necessity Goods: 0 E D,I 1 (e.g. water, clothing) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
17 Income Effect Income Elasticity of Demand How much does an individual change their quantity demanded when their income changes? E D,I = % Q D % I = Q Q I I = Q D I I Q D The income effect is given by (the sign of) Q D I If E D,I is positive: Q D I > 0: A normal good, buy more units of the good when you have more income. Two subtypes of normal goods: Necessity Goods: 0 E D,I 1 (e.g. water, clothing) Luxury Goods: E D,I > 1 (e.g. vacations, jewelry, Filet Mignon) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
18 Income Effect Example You can spend your income on golf and pancakes. Green fees at a local golf course are $10 per round and pancake mix is $2 per box. When your income is $100, you buy 5 boxes of pancake mix and 9 rounds of golf. When your income increases to $120, you buy 10 boxes of pancake mix and 10 rounds of golf. What type of good is golf (Inferior, Normal (necessity or luxury)? What type of good are pancakes (Inferior, Normal (necessity or luxury)? Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
19 Income Effect Example Is the environment a normal good? Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
20 Income Effect Example Is the environment a normal good? Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
21 Income Effect The income expansion path describes how consumption of two goods change when income increases Goolsbee et al. (2011: 169) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
22 Income Effect The Engel curve is more helpful, and describes how consumption of one good change when income increases Goolsbee et al. (2011: 171) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
23 Lesson Plan 1 Framework and Assumptions 2 Income Effects 3 Deriving Demand Curves Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
24 Deriving a Demand Curve An individual s demand curve defines a relationship between the price of a good and the quantity demanded of that good We need to see how consumers respond to changes in price (we just saw changes in income) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
25 Deriving a Demand Curve Burritos With constant income of $50: When P L = $20, buys 2L U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
26 Deriving a Demand Curve Burritos With constant income of $50: When P L = $20, buys 2L When P L = $10, buys 3L U 2 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
27 Deriving a Demand Curve Burritos With constant income of $50: When P L = $20, buys 2L When P L = $10, buys 3L When P L = $5, buys 6L U 2 U 3 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
28 Deriving a Demand Curve Burritos When P L = $20, buys 2L U P L Lattes Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
29 Deriving a Demand Curve Burritos When P L = $20, buys 2L When P L = $10, buys 3L U 2 1 U P L Lattes Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
30 Deriving a Demand Curve Burritos When P L = $20, buys 2L When P L = $10, buys 3L When P L = $5, buys 6L U 2 U 3 U P L Lattes Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
31 Deriving a Demand Curve Burritos When P L = $20, buys 2L When P L = $10, buys 3L When P L = $5, buys 6L U 2 U 3 U P L Demand Lattes Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
32 Deriving a Demand Curve: Income Effect Suppose there is only 1 good, X. You have a $100 income, and the price of X is $10. You consume 10 units of X. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
33 Deriving a Demand Curve: Income Effect Suppose there is only 1 good, X. You have a $100 income, and the price of X is $10. You consume 10 units of X. Suppose the price falls to $5 per unit of X. Your consumption increases to 20 units of X. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
34 Deriving a Demand Curve: Income Effect Suppose there is only 1 good, X. You have a $100 income, and the price of X is $10. You consume 10 units of X. Suppose the price falls to $5 per unit of X. Your consumption increases to 20 units of X. This is the income effect. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
35 Deriving a Demand Curve: Income Effect Suppose there is only 1 good, X. You have a $100 income, and the price of X is $10. You consume 10 units of X. Suppose the price falls to $5 per unit of X. Your consumption increases to 20 units of X. This is the income effect. A change in the price of X changes your real income: the amount of goods you can buy. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
36 Deriving a Demand Curve: Income Effect Suppose there is only 1 good, X. You have a $100 income, and the price of X is $10. You consume 10 units of X. Suppose the price falls to $5 per unit of X. Your consumption increases to 20 units of X. This is the income effect. A change in the price of X changes your real income: the amount of goods you can buy. Note your nominal income of $100 never changed. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
37 Deriving a Demand Curve: Income Effect Suppose there is only 1 good, X. You have a $100 income, and the price of X is $10. You consume 10 units of X. Suppose the price falls to $5 per unit of X. Your consumption increases to 20 units of X. This is the income effect. A change in the price of X changes your real income: the amount of goods you can buy. Note your nominal income of $100 never changed. The income effect is more important for goods that are a large part of our budget: i.e. housing/apartment rents vs. pencils. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
38 Deriving a Demand Curve: Substitution Effect Suppose instead there are 1000s of goods, none of them are a large fraction of your budget. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
39 Deriving a Demand Curve: Substitution Effect Suppose instead there are 1000s of goods, none of them are a large fraction of your budget. Suppose the price of one good, Y, rises. Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
40 Deriving a Demand Curve: Substitution Effect Suppose instead there are 1000s of goods, none of them are a large fraction of your budget. Suppose the price of one good, Y, rises. The income effect is tiny (and negative). Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
41 Deriving a Demand Curve: Substitution Effect Suppose instead there are 1000s of goods, none of them are a large fraction of your budget. Suppose the price of one good, Y, rises. The income effect is tiny (and negative). But you would consume fewer of units of Y, the substitution effect because the relative price of Y has gone up Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
42 Demand Curves: Income & Substitution Effects An individual s demand curve defines a relationship between the price of a good and the quantity demanded of that good Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
43 Demand Curves: Income & Substitution Effects An individual s demand curve defines a relationship between the price of a good and the quantity demanded of that good When the price falls for a good, people buy more of that good; this is known as the price effect Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
44 Demand Curves: Income & Substitution Effects An individual s demand curve defines a relationship between the price of a good and the quantity demanded of that good When the price falls for a good, people buy more of that good; this is known as the price effect But there are two effects that combined create the price effect: Substitution Effect: change in consumption due to change in relative prices If X gets cheaper relative to Y, consume less Y (and more X ) This is always negative! (away from relatively more expensive good) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
45 Demand Curves: Income & Substitution Effects An individual s demand curve defines a relationship between the price of a good and the quantity demanded of that good When the price falls for a good, people buy more of that good; this is known as the price effect But there are two effects that combined create the price effect: Substitution Effect: change in consumption due to change in relative prices If X gets cheaper relative to Y, consume less Y (and more X ) This is always negative! (away from relatively more expensive good) Income Effect: change in consumption due to increase in real purchasing power This can be positive (normal) or negative (inferior)! Lower price of X means you can buy more of both X and Y (depending on preferences) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
46 Demand Curves: Income & Substitution Effects An individual s demand curve defines a relationship between the price of a good and the quantity demanded of that good When the price falls for a good, people buy more of that good; this is known as the price effect But there are two effects that combined create the price effect: Substitution Effect: change in consumption due to change in relative prices If X gets cheaper relative to Y, consume less Y (and more X ) This is always negative! (away from relatively more expensive good) Income Effect: change in consumption due to increase in real purchasing power This can be positive (normal) or negative (inferior)! Lower price of X means you can buy more of both X and Y (depending on preferences) Price effect = Income effect + Substitution effect Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
47 Demand Curves: Income & Substitution Effects Burritos U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
48 Demand Curves: Income & Substitution Effects Burritos As the price of lattes falls, the total price effect is buying 4 more lattes and 1 more burrito U U Total Effect Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
49 Demand Curves: Income & Substitution Effects Burritos 10 9 As the price of lattes falls, the total price effect is buying 4 more lattes and 1 more burrito We can isolate this total effect into the two component substitution and income effects U U Total Effect Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
50 Demand Curves: Income & Substitution Effects Burritos C 4 U A 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
51 Demand Curves: Income & Substitution Effects Burritos Substitution effect: what would have been chosen at the new price while maintaining the same utility as before the price change C 4 U A 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
52 Demand Curves: Income & Substitution Effects Burritos Substitution effect: what would have been chosen at the new price while maintaining the same utility as before the price change Graphically: shift the new budget constraint in until tangent with old indifference curve C 4 U A 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
53 Demand Curves: Income & Substitution Effects Burritos Substitution effect: what would have been chosen at the new price while maintaining the same utility as before the price change Graphically: shift the new budget constraint in until tangent with old indifference curve Movement from A to B (giving up other more expensive good) S.E. -1B A B C U 1 U Substitution Effect +1L L Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
54 Demand Curves: Income & Substitution Effects Burritos C 4 U A B 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
55 Demand Curves: Income & Substitution Effects Burritos Income effect: the change in quantities demanded due to the change in purchasing power after the change in prices I.E. +3B A B C U 1 U Income Effect +1L Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
56 Demand Curves: Income & Substitution Effects Burritos Income effect: the change in quantities demanded due to the change in purchasing power after the change in prices Graphically: move from B to C on new budget line I.E. +3B A B C U 1 U Income Effect +1L Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
57 Demand Curves: Income & Substitution Effects Burritos C 4 U A B 1 U Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
58 Demand Curves: Income & Substitution Effects Burritos C 4 U A B 1 Subs -1B U Subs +1L Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
59 Demand Curves: Income & Substitution Effects Burritos C 4 U 2 3 Inc +3B 2 A B 1 Subs -1B U Subs +1L Inc +1L Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
60 Demand Curves: Income & Substitution Effects Burritos C 4 U 2 Total +2B 3 Inc +3B 2 A B 1 Subs -1B U Subs +1L Inc +1L Total +2L Lattes Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
61 Income & Substitution Effects Goolsbee et al. (2012: 175) The size of the substitution effect depends on how [not] substitutable the goods are (how straight [bent] the indifference curve) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
62 Income & Substitution Effects Again, the size of the income effect depends on how big of a portion of your budget you were spending on the good Income effect of change in price of housing vs. pencils Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
63 Income & Substitution Effects (Inferior Good) Goolsbee et al. (2012: 178) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
64 Income & Substitution Effects ( Giffen Good) Goolsbee et al. (2012: 179) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
65 Demand Curves: Income & Substitution Effects Goolsbee et al. (2012: 181) Ryan Safner (Hood College) ECON Lesson 5 Fall / 31
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