Microeconomics: Lecture 6

Market Demand

Consumer Theory: Roadmap

Building blocks Preferences and Axioms of Rationality (Part I) Part II Representation of Rational Preferences: Utility Affordable Bundles: Budget Set Part III A model of Consumer Choice: Utility Maximization: Derivation of Individual Demand Today: Last Part Derivation of Market Demand Two Levels of Rationality: In Preferences and in Choices

Roadmap Market Demand

Market Demand: horizontal summation of
individual demands

Elasticity of Demand Consumer Surplus Estimation of Demand

Market Demand
Market Demand Curves
A curve that relates the quantity of a good that
all consumers in a market buy to the price of that good

The sum of all the individual demand curves in

the market

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Determining the Market Demand Curve

Price $1 $2 $3 $4 $5
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A 6 4 2 0 0

B 10 8 6 4 2

C 16 13 10 7 4

Market Demand

Summing to Obtain a Market Demand Curve

Price 5 4 3 2 1
The market demand curve is obtained by summing the consumers demand curves

DA
5

DB
10 15

DC
20 25 30 Quantity
6

0
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Market Demand

From this analysis one can see two important points:

The market demand curve will shift to the right as more

consumers enter the market

Factors that influence the demands of many consumers will

also affect market demand

Aggregation is important to be able to discuss demand for different groups

Households with children are more likely to purchase

minivans

Rural Consumers are more likely to buy pickup trucks

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Probability purchasing a car

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Price Elasticity of Demand

Measures the percentage change in the
quantity demanded resulting from a percent change in price

% Q Q/Q EP % P P/P EP
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Price Elasticity of Demand

Inelastic Demand
Ep is less than 1 in absolute value Quantity demanded is relatively
unresponsive to a change in price

|%Q| < |%P| Total expenditure (P*Q) _________when

price increases
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Price Elasticity of Demand

Elastic Demand
Ep is greater than than 1 in absolute value Quantity demanded is relatively
responsive to a change in price

|%Q| > |%P| Total expenditure (P*Q)________ when

price increases
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Price Elasticity of Demand

Isoelastic Demand
When price elasticity of demand is constant
along the entire demand curve

Demand curve is curved inwards (not

linear)

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Gasoline vs. Grapefruits

For every 10 percent increase in price during the late
1970s, demand fell 2.1 to 3.4 percent, researchers found. But in the past five years, every 10 percent price increase drove down gasoline purchases by a mere 0.34 to 0.77 percent. Gas prices hardly affect demand
- David R. Baker, Staff Writer, Friday, December 1, 2006

But last fall, with the grapefruit crop down substantially, consumer demand for grapefruit juice plummeted by as much as 30 percent after prices increased 20 percent and more.

By ANDREW MARTIN Published: December 2, 2006

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Price Elasticity of Demand: Illicit Drugs

Author (s) Nisbet & Vakil Silverman & Spruill Van Ours Caulkins Brettville Jensen & Sutton Grossman & Chaloupka Saffer & Chaloupka Date 1972 1977 1995 1996 1996 Drug (s) Marijuana Heroin Opium Cocaine & Heroin Heroin Data Questionnaire of UCLA students Monthly data (1970-1973) from Detroit Government data (19231938) Drug Use Forecasting System and STRIDE Questionnaire of Norwegian addicts Monitoring the Future Survey (1976 - 1985) and STRIDE National Household Survey on Drug Abuse (1988, 1990, 1991) Monitoring the Future Survey (1982 and 1999) Monitoring the Future Survey (1988 - 2000) Elasticity Estimates -0.36 (lower bound) -1.51 (upper bound) -0.27 (long-run) -0.7 (short-run) -1.0 (long-run) -2.5 (cocaine) -1.5 (heroin) -0.20 (dealers) -1.23 (non-dealers) -0.96 (short-run) -1.35 (long-run) -0.55 & -0.80 (cocaine, past-year & past-month) -0.90 & -0.36 (heroin, past-year & pastmonth) -0.89 (past-year) -0.98 (past-month) -0.23 (cocaine) -0.08 (heroin)

1998

Cocaine

1998

Cocaine & Heroin

Chaloupka et al. Dave

1999 2003

Cocaine Cocaine & Heroin

Price Elasticity of Demand: Cigarettes

Lowest Estimate Mean Estimate Highest Estimate Aggregate Consumption Data (22 US studies) -0.14 -0.387 -1.12

Aggregate Consumption Data (6 international studies; Developed Countries)

-0.245

-0.6

Developing Countries (8 studies)

Individual Consumption Data on Adults (7 US studies) Youth Prevalence (16 US studies) Youth Consumption (12 US studies)

-0.1

-0.598

-1.0

-0.25

-0.374

-0.47

-0.579

-1.21

-0.608

-1.44

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Consumer Surplus
Consumers buy goods because it makes them
better off

Consumer Surplus measures how much better

off they are

The difference between the maximum amount a

consumer is willing to pay for a good and the amount actually paid

Can calculate consumer surplus from the demand

curve
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Consumer Surplus Example

Student wants to buy concert tickets Demand curve tells us willingness to pay for
each concert ticket

1st ticket worth $20 but price is $14 so student

generates $6 worth of surplus

Can measure this for each ticket Total surplus is addition of surplus for each ticket
purchased
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Consumer Surplus Example

Price ($ per ticket)

20 19 18 17 16 15 14 13

The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually.

Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 =? Market Price

Will not buy more than 7 because surplus is negative

0
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Rock Concert Tickets 18

Consumer Surplus
Price ($ per ticket)

20 19 18 17 16 15 14
Consumer Surplus

Consumer Surplus for the Market Demand

CS =

Market Price Demand Curve Actual Expenditure

13

0
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Rock Concert Tickets

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The Boss Gives Away Consumer Surplus!

Survey at Springsteen The Rising Concert,
Oct. 6, 2003 in Philadelphia, PA. Every ticket sold for $75. Stratified random cluster sample of seats. Interviewed 858 people in the 15 minutes before the start of the show. Short questionnaire on index card. Very high response rate. 20-25 percent of tickets scalped. Worst seats more likely to be resold. Average resale price was $300. Springsteen gave away $3 million in consumer surplus
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Empirical Estimation of Demand

The Statistical Approach to Demand

Estimation

Properly applied, the statistical approach

to demand estimation can enable one to sort out the effects of variables on the quantity demanded of a product

Least-squares regression is one

approach

Endogeneity Problem

I observe the following for a hotel in

Bar Harbor, Maine:

Summer Price: $300, full hotel: 30 rooms

booked.

Winter Price: $120, 2 rooms used.

Does this mean that the demand curve

slopes upward?

Demand Data for Raspberries

Empirical Estimation of Demand

Assuming only price determines

demand:

Q = a - bP Q = 28.2 -1.00P

Assuming there are other effects on

demand (other prices, incomes)

Q =a bP -cPother+dI

Estimating Demand
Price 25

20 15 d1 10 5 0 5 10

D represents demand if only P determines demand and then from the data: Q=28.2-1.00P

d2
d3 15 20

25 Quantity

Estimating Demand Changes in Income

Price

25 20 15 d1 10 5 0 5 10

d1, d2, d3 represent the demand for each income level. Including income in the demand equation: Q = a - bP + cI or Q = 8.08 - .49P + .81I

d2
d3 15 20

25 Quantity

Empirical Estimation of Demand

Estimating Elasticities
For the demand equation: Q = a - bP

Elasticity:

EP (Q / P)( P / Q) b( P / Q)

Empirical Estimation of Demand

Using the Raspberry data:

log(Q) 0.81 0.24 log( P) 1.46 log( I )
Price elasticity = -0.24 (Inelastic) Income elasticity = 1.46

Empirical Estimation of Demand

Complements and Substitutes

log(Q) a b1 log( P) b2 log P2 c log( I )

Substitutes: b2 is positive Complements: b2 is negative

Summary

Market demand Elasticity of Demand Consumer Surplus Demand Estimation

Required Reading

The required for Lecture 5 is:

Pindyck and Rubinfeld, 7th edition, Chapter 4,

pp. 125-135, 140-144

Pindyck and Rubinfeld, 7th edition, Chapter 2,

pp. 34-40

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