Individual and Market Demand: Chapter Outline

Individual and Market Demand
k 5
Chapter outline
5.1 How Income Changes Affect an
Individual’s Consumption Choices
5.2 How Price Changes Affect
Consumption Choices
5.3 Decomposing Consumer
Responses to Price Changes into Income
and Substitution Effects
5.4 The Impact of Changes in Another
Good’s Price
5.5 Combining Individual Demand
Curves to Obtain the Market Demand
Curve
5.6 Conclusion
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 5-1
Introduction 5
With the consumer choice framework in place, we now link
consumer decisions with individual and market demand
These links help determine
• Why shifts in tastes affect prices
• What benefits producers offer consumers
• How income and wealth affect purchase patterns
• What determines how consumers respond to price changes
5.1
How Income Changes Affect an
Individual’s Consumption Choices 5
The income effect is the change in optimal consumption choices associated
with a change in income (or purchasing power), holding relative prices constant
Is higher income associated with higher consumption of goods?
It depends!
For normal goods, higher income is associated with rising consumption
• For instance, consider Fancy Meals and Vacations, both of which are considered
normal goods
5.1
Figure 5.1 A Consumer's Response to an Increase in Income When
Both Goods Are Normal
Vacations
Income
rises
B

Qv A
U2
U1
BC1 BC2
Qm Fancy meals

5.1
with a change in income (or purchasing power), holding relative prices constant
It depends!
Alternatively, for inferior goods, higher income is associated with falling
consumption
• Consider boxed macaroni and cheese (inferior good) vs. steak (a normal good)
5.1
Figure 5.2 A Consumer's Response to an Increase in Income When
One Good is Inferior
Quantity of
Mac and
cheese
Qmac A
B

U1 Income
U2 rises
BC1 BC2
Qs Quantity
of steak
5.1
Income Elasticities and Types of Goods
Chapter 2 introduced the concept of elasticity
• Income elasticity describes the response of demand to changing income
• Specifically, the percentage change in quantity consumed associated with a
percentage change in income
Mathematically, %Q Q / Q Q I
E  D
I  
%I I / I I Q
where I is income and Q is the quantity of a good demanded
The income effect is given by
Q
I
5.1
Income Elasticities and Types of Goods
Thus, the sign of the income elasticity is the same as the income effect
Q
If E  0   0 , the good in question is a normal good
D
I
I
Q
If E I  0   0 , the good in question is an inferior good
D
I
Application 5
Is the Environment a Normal Good?
While usually not priced in the market, consumers have preferences
for environmental quality just like any other good
• Most economists believe the environment is a normal good
• Poorer countries are often characterized by environmentally
damaging industrial processes; perhaps citizens are choosing
improved income over environmental quality
• As income-per-capita improves, pollution should fall
• This hypothesis is known as the “Environmental Kuznets Curve”
(EKC)
Vollebergh, et al. (2009) find evidence for the EKC for sulfur
dioxide emissions in a panel of OECD countries
Images: FreeDigitalPhotos.net
They find no similar evidence for carbon dioxide
Citation: Vollebergh, H. R. J., Melenberg, B., and Dijkgraff, E. 2009. “Identifying reduced form relations with panel data: The
case of pollution and income.” Journal of Environmental Economics and Management 58: 27-42.
Application 5
The Inverted U-Shape
As income rises, pollution will rise at first because
consumers are trading off environmental protection for
Pollution other goods
per-capita
Eventually, as income hits some threshold, consumers
demand greater environmental protection
At this point, pollution-per-capita begins to fall
Income per
capita
Application 5
Caveats:
• Because markets for environmental goods and services are often
lacking or non-existent, they are often under-supplied
• Without strong property rights or an effective central authority, the
EKC hypothesis will likely fail
• Additionally, as income grows, production processes generally
become more efficient on their own, and economies transition to less
polluting service sectors
• Many economists dispute the presence of a demand-driven inverted
U-shape for most pollutants
Images: FreeDigitalPhotos.net
5.1
with a change in income (or purchasing power) ), holding relative prices
constant
It depends!
Alternatively, for inferior goods, higher income is associated with falling
consumption
There are two additional sub-types of goods that are common
• Necessity goods: normal goods for which income elasticity is between zero and 1
(e.g., water consumption)
• Luxury goods: normal goods for which income elasticity is greater than 1 (e.g.,
vacation homes)
Eating out vs. paperback books Figure it out
Steve spends all of his income on meals at restaurants and

paperback novels. His usual restaurant meal costs $25, and
paperback books cost $8.
When Steve’s monthly income is $240, he goes out to eat 8 times
and purchases 5 books. When his income rises to $282, he goes out
to eat 10 times and purchases 4 books.
Determine whether the following statements are true:
1. Restaurant meals are normal goods, and paperback books are
inferior goods
2. Restaurant meals are luxury goods
3. Paperback books are necessity goods
1. A normal good is subject to increased consumption when

income rises; an inferior good is subject to decreased
consumption when income rises
When Steve’s income rises, he purchases more restaurant
meals and less paperback books; thus, the statement is
true.
2. Luxury goods are characterized by an income elasticity greater
than 1.
E 
D %Q Q / Q
 
 10  8 / 8

0.25
 1.43
I
%I I / I  282  240 / 240 0.175
The income elasticity for restaurant meals is 1.43, and so restaurant
meals are indeed luxury goods
3. Necessity goods are characterized by an income elasticity

greater than zero but less than 1.
E 
D %Q Q / Q
 
 4  5 / 5

 0.2
 1.14
I
%I I / I  282  240 / 240 0.175
The income elasticity for books is -1.14, indicating books are an
inferior good. The original statement is false.
5.1
Tracing the optimal bundle of goods chosen as income increases results in the
income expansion path
• Helps determine whether a good is normal or inferior, but only two goods represented
• Can’t directly observe income levels on the curve (both axes represent quantities of
goods)
A more common way to describe the consumption-income relationship is with
an Engel curve
• Shows the relationship between quantity consumed of one good and consumer income
5.1
Figure 5.3 The Income Expansion Path
5.1
Figure 5.4 An Engel Curve Shows How Consumption Varies with
Income
Income Income
At point D Bottled water
/ week / week
rides become is normal at all Engel
$35 Engel inferior $35 income levels
curve curve
E E
30 30
D
25 D 25
C
20 C 20
B
15 15
B
10 A 10 A
5 5
0 1 2 3 4 5 6 7 8 Bus 0 1 2 3 4 5 6 7 8 9 Bottled
rides water
Application 5
The EKC Hypothesis revisited
Returning to the previous example, we can uncover
how the U-shape is equivalent to an Engle curve by
switching the axes
Income per
capita While environmental quality is a normal good,
pollution is an inferior good, as the shape of this curve
suggests
Pollution per-capita
5.2
How Price Changes Affect
Consumption Choices 5
Just as income affects consumer choices, changes in relative prices—holding
income constant—also affects these choices
Deriving a Demand Curve
• Demand curves define a relationship between quantity demanded and price
• To derive a demand curve, we must understand how a consumer responds to a change
in price
• By changing one price on an indifference curve – budget constraint map, we can
observe changes to consumer choices and then build the demand curve for an
individual
• The observed price represents the maximum willingness to pay for the last unit
consumed
5.2
Figure 5.7 Building an Individual's Demand Curve
Mountain Dew
PG = 4 PG = 1
(2 liter bottles) Income = $20
PG = 2 PG = $1
10
PMD = $2
4
3
2 U3 U1
U2
0
3 5 8 10 14 20
Quantity of grape juice
(1 liter bottles)
Price of
grape juice
($/bottle)
Carolyn’s
$4 demand for
2 grape juice
1
0
3 8 14
(1 liter bottles)
5.2
Shifts in the Demand Curve
When consumer preferences, income, or the prices of other goods change, the
demand curve will shift
Consider the example of Mountain Dew and grape juice from the previous
figure
• Imagine the consumer prefers the taste of Mountain Dew, but had previously limited
consumption due to worries about high fructose corn syrup
• After hearing advertisements from the Corn Refiners Association claiming corn
syrup is identical to cane sugar, her fears are reduced
 What might happen to the demand for grape juice?
5.2
Figure 5.8 Preference Changes and Shifts in the Demand Curve
Quantity of
(a) Caroline’s indifference curves for grape
Mountain Dew
PG = 4 PG = 1 juice flatten when her preference for grape
(2 liter bottles)
juice decreases relative to her preference
PG = 2
10 for Mountain Dew. At each price level, she
now consumes fewer bottles of grape juice.
6
5.5
4
PG = 4 U 3
PG =U22 U
P1G = 1
0 2 6 9 20
(1 liter bottles)
Price of
grape juice
($/bottle)
( b) Because she purchases fewer bottles of
grape juice at each price point, Caroline’s
demand curve for grape juice shifts inward
$4 D2 from D1 to D2.
2
1 D1
0 2 6 9
(1 liter bottles)
The Effect of a Price change Figure it out
Mark has $200 per month to spend on movie tickets (M) and theater tickets
(T); movie tickets cost $10 each, and theater tickets cost $50 each
a. With theater tickets on the horizontal axis, draw Mark’s budget constraint and
indicate the horizontal and vertical intercepts
b. Suppose Mark currently purchases 30 theater tickets. Indicate this choice on the
graph with the letter A and draw an indifference curve
c. Now, suppose the price of theater tickets rises to $80. Mark now purchases two
theater tickets. Indicate this point with the letter B and draw a new indifference
curve
d. Finally, suppose the price of theater tickets rises again to $100. Mark purchases
one theater ticket. Indicate this point with the letter C and draw a new
indifference curve
e. Draw a new diagram showing Mark’s demand curve for theater tickets
The Effect of a Price change Figure it out
First plot the different bundles
Then the demand curve
Movie Price
tickets
20 100 C
80 B
C
10 50
A
A
5
4 B
0 0
1 2 2.5 3 4 Theater 1 2 3 Theater
tickets tickets
Decomposing Consumer Responses to
5.3 Price Changes into Income and
Substitution Effects 5
When the price of a good changes relative to another, two things happen
1. One good becomes relatively more expensive, and the other relatively less
2. The total purchasing power of a consumer’s income changes
The substitution effect refers to the change in consumption choices resulting
from a change in relative prices
• Always negative; when the price of one good relative to another increases,
consumption of the former falls, and vice versa
The income effect refers to the change in consumption choices resulting from a
change in purchasing power
• This is the same income effect from Section 5.1
• Can be negative or positive (inferior or normal goods)
The total effect of a change in a price is the sum of the substitution and income
effects
• The total effect is simply the observed change in consumption of a good after a price
change
Total Effect  Substitution Effect  Income Effect
Figure 5.9 The Effects of a Fall in the Price of Restaurant Meals
Rounds
of golf
B
Total 6
effect A
5
U2
U1
BC1 BC2
0 3 5 Restaurant
meals
Total effect
The total effect is the sum of the substitution and income effects
change
Isolating the Substitution Effect

• Determine the bundle of goods that would have been chosen at the new price while
maintaining utility experienced before the price change
• To do this for a fall in the price of restaurant meals, shift the new budget constraint
inward until it is tangent with the old indifference curve
Figure 5.10 Substitution Effects and Income Effects for Two Normal
Goods(a)
(b)
(c)
Rounds
of golf
Total effect
(+ 1 round of golf)
B
6
Income A
5
U2
effect
A′
3
Substitution U1
BC2
effect BC1 BC′
0 3 4 5 Restaurant
meals
Substitution effect Income effect
Total effect (+ 2 restaurant meals)

The total effect is the sum of the substitution and income effects
change
Isolating the Substitution Effect

• Determine the bundle of goods that would have been chosen at the new price while
maintaining utility experienced before the price change
• For a fall in the price of restaurant meals, shift the new budget constraint inward
until tangent with the old indifference curve
• Restaurant meals are normal goods; therefore, the income effect is positive
Isolating the Income Effect
• The income effect is the total effect minus the substitution effect
Three steps to computing substitution and income effects associated with a
price change. Starting with a consumer at bundle A
1.Draw the new budget constraint and find the new optimal bundle (B )
• A price change for one of two goods rotates or pivots the constraint
2.Draw a line parallel to the new budget constraint, but tangent to the old
indifference curve; determine the optimal bundle on the old curve associated
with this theoretical budget constraint (A′)
3.The substitution effect is the difference in quantities between A and A′ and
the income effect is the difference in quantities between A′ and B
What Determines the Size of the Substitution and Income Effects?
Curvature: The size of the substitution effect depends on the curvature of

indifference curves
 What does it mean when an indifference curve is relatively straight?
 What does this say about the size of the MRS along a straighter curve?
 Is the substitution effect larger or smaller along a straighter curve?
Quantity consumed before the price change: The income effect increases
with the amount spent on a good before a price change
 Why does the income effect increase with the amount spent on a good?
The Effect of a Price Change Figure it out
Monica eats chips and crackers. Her income is $20, and the price of chips and crackers are $1
and $2 per bag, respectively.
At these prices, she eats 16 bags of chips and two bags of crackers (point A )
When the price of crackers falls to $1, Monica consumes 8 bags of chips and 12 bags of
crackers (point B )
Chips Answer the following
1. Why does the budget constraint rotate?
20
2. Label your own diagram and estimate
the income and substitution effects for
16
A crackers. Which is larger?
Total U1 3. Are crackers a normal or inferior good?
effect 12
Chips?
8 B
4 U2
BC1 BC2
0 Crackers
2 4 8 12 16 20
Total effect
The Effect of a Price Change Figure it out
1. The price of chips has not changed, and so Monica can still buy 20 bags of chips if she so
chooses; however, she can now afford twice as many crackers (20 bags)
2. The substitution effect is measured by holding utility at the pre-change level, and
considering Monica’s optimal bundle with the new price ratio, A′
The income effect is the remainder of the
Chips difference between A and B. The income
effect is larger for crackers.
20
A′ 3. Crackers are a normal good since
16 Monica purchases more when her
A purchasing power increases (the
14
U1 income effect is positive)
12
Chips, on the other hand, are
8 B inferior; Monica purchases fewer
chips when her purchasing power
increases
4 U2
BC1 BC′ BC2
0 Crackers
2 4 8 12 16 20
Sub. effect Inc. effect
An Example of the Substitution and Income Effects for an Inferior Good
It is important to see how the income and substitution effects are opposed to
one another with an inferior good.
Consider a consumer choosing bundles of steak and hamburger
Figure 5.13 A Fall in the Price of an Inferior Good
Figure 5.14 Substitution and Income Effects for an Inferior Good
(a)
(b)
(c)
Steak
Total effect
(more steak) B
U2
Income
A
effect
A′
Substitution
effect U1
BC1 BC′ BC2
Ramen
Total effect Income noodles
(more ramen noodles) effect
Substitution effect
Application 5
Price Changes and Willingness to Pay
In addition to providing insight to income and
Chips U1 substitution effects, the previous graphical analysis
20 reveals information about how price changes affect
A′ consumer welfare
16 Consider again the price change in crackers for
A Monica; she is clearly better off; her new budget
10
constraint contains a larger set of feasible bundles
12
Exactly how much better off is she?
8 B
Simple: by the amount of income we could take
away, leaving Monica at her original utility level!
4 U2 We call this compensating variation, and it looks
BC1 BC′ BC2 to be about $3 in this case
0 Crackers
2 4 8 12 16 20
Citation: Shogren, J. F., Shin, S. Y., Hayes, D. J., and Kliebenstein, J. B. 1994. “Resolving Differences in Willingness to Pay
and Willingness To Accept.” The American Economic Review 84(1): 255-270.
Application 5
Price Changes and Willingness to Pay
Monica should be willing to pay $3 to experience a lower price
on crackers, and she should be willing to accept $3 in lieu of
the price change
The theoretical equivalency between willingness to pay (WTP)
and willingness to accept (WTA) extends to quantity
differences Images: FreeDigitalPhotos.net
In practice, however, WTA for a product a consumer currently

owns generally exceeds WTP for that same product
Application 5
Shogren, et al. (1994) investigate this anomaly using a lab
experiment with human subjects
Using candy bars and coffee mugs, the authors find that with
repeated market experience, the divergence WTP-WTA
estimates disappears
• This result hinges on substitutability; participants were given access
to a “market” for products
• This market was on-site (so no cost of going to store, etc.) Images: FreeDigitalPhotos.net
• Non-market goods with limited substitutability (specifically,

changes in risk of food-borne illness) exhibited persistent
divergence between WTP and WTA
Giffen goods are goods for which quantity demanded increases as price rises
• Inferior goods, but the income effect outweighs the substitution effect
• Results in an upward sloping demand curve
When the price of a Giffen good drops, the substitution effect (which acts to
increase demand) is smaller than the income effect
Economists sometimes question whether Giffen goods actually exist

• The few examples with humans tend to focus on very poor households and
commodity crops (e.g., rice and potatoes)
Figure 5.15 A Change in the Price of a Giffen Good
Application 5
Rats, Quinine, and Giffen Behavior
Battalio, et al. (1990) found existence of Giffen behavior in rats
using quinine solution (tonic water) and root beer
• Rats prefer root beer to water, and water to quinine solution
Rats were given limited “lever-pulls” to release liquid, and root

beer pulls released less liquid than the quinine pull (no water
was available during the experiment) Images: FreeDigitalPhotos.net
Findings imply quinine solution is a Giffen good for rats

• First, quinine solution was shown to be an inferior good (negative
income effect)
• Second, when the price of quinine solution was lowered (more
volume per pull), the average rat reduced volumetric consumption,
shifting to root beer instead
Citation: Battalio, R. C., Kagel, J. H., and Kogut, C. A. 1991. “Experimental Confirmation of the Existence of a Giffen
Good.” The American Economic Review 81(4): 961-970.
The Impact of Changes in Another
5.4 Good’s Price: Substitutes and
Complements 5
A Change in the Price of a Substitute Good
When the price of a substitute good increases, we expect consumption of the
primary good to increase
• Consider Pepsi-Cola and Coca-Cola
Complements 5
Figure 5.17 When the Price of a Substitute Rises, Demand Rises
Pepsi At original prices, this consumer purchases 16
20 bottles of Pepsi and 4 bottles of Coke
Pepsi A When the price of Pepsi doubles, Coke
consumption 16 consumption increases by 200% (to 12 bottles),
falls U1
and Pepsi consumption falls by 75% (to 4 bottles)
12
Coke consumption rose when the price of Pepsi
rose: they are substitutes
8 BC2 U2 BC1
B
4
0
4 8 12 16 20 Coke
Coke consumption rises
Complements 5
When the price of a complement increases, we expect consumption of the
primary good to decrease
• Consider tortilla chips and salsa
Complements 5
Consider the example of chips and salsa
At original prices, this consumer purchases 4
Salsa jars of salsa and 12 bags of chips
10
BC1 When the price of salsa doubles, consumption
Chip price of salsa falls by 25% (to 3 jars), and
8
doubles consumption of chips by 33% (to 8 bags)
6 Since chips and salsa are complements, when

BC2 the price of salsa rose, chip consumption fell
A
4
B U2 U1
2
0
4 8 12 16 20 Chips
Salsa consumption falls
Complements 5
When the price of a complement increases, we expect consumption of the
primary good to decrease
• Consider tortilla chips and salsa
These relationships help to explain the shifts in demand examined in Chapter 2
Complements 5
Figure 5.19 Changes in the Prices of Substitutes or Complements
Shift the Demand Curve
Combining Individual Demand
5.5 Curves to Obtain the Market Demand
Curve 5
The final step linking consumer theory to market demand is probably the
easiest
• Market demand is the horizontal sum of individual demand curves
• The market quantity demanded at each price is the sum of the individual quantities
demanded at each price
• The market demand curve is found by summing horizontally individual demand
curves
Consider the market for scooters
Curve 5
Figure 5.21 The Market Demand Curve
(b)
(a)
(c)
Price
($/scooter) B
$52
40
A
20
Dcousin Dmarket =
Dyou Dyou + Dcousin
0 34 6 8 12
Quantity of scooters
Curve 5
The final step linking consumer theory to market demand is the easiest
• Market demand is simply the sum of individual demand
• The total quantity demanded at each price is the sum of every individual’s quantity
demanded at each price
• The market demand curve is found by summing horizontally individual demand
curves
Consider the market for scooters
Algebraically, market demand is given by
Qmarket  Qyou  Qcousin  5  0.5 P  13  0.25P  18  0.3P
The difference in choke prices implies your demand function is the market demand
function for prices between $52 (cousin’s choke price) and $100 (your choke price); the
market demand function applies to prices less than $52
Demand for Gasoline Figure it out
Jim and Alice are the only customers of a local gas station. Jim
drives a motorcycle, and Alice a sport utility vehicle
Jim’s demand for gasoline is given by QJ  15  3P
and Alice’s by QA  30  5 P
Answer the following:
1.Compute the market demand equation for gasoline
2.Draw a diagram showing the market demand for gasoline
1. Market demand is found by adding individual demand

Qmarket  QJ  QA  15  3P  30  5 P  45  8 P
However, it is necessary to compute choke prices. Jim’s choke price
is given by
QJ  0  15  P  P  5
c
and Alice’s by QA  0  30  3P  P c  6
When the price of gas rises above $5, only Alice will purchase
gasoline; at prices less than $5, the horizontally summed curve
applies
45  8 P if P  5
Qmarket 
30  5 P if P  5
2. The market demand curve
Price
1 Dmarket
0 Gallons
5 8 16 24 32 40 48
5.6 Conclusion 5
This chapter concludes our in-depth analysis of the consumer side
of the supply and demand model. We
• Examined how income and prices affect consumer choices
• Made the link between consumer theory and market demand
In Chapter 6 we begin a parallel in-depth examination of producer
behavior

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Individual and Market Demand

Steve spends all of his income on meals at restaurants and

1. A normal good is subject to increased consumption when

3. Necessity goods are characterized by an income elasticity

 What might happen to the demand for grape juice?

First plot the different bundles

Then the demand curve

Total Effect  Substitution Effect  Income Effect

Isolating the Substitution Effect

Total effect (+ 2 restaurant meals)

Total Effect  Substitution Effect  Income Effect

Isolating the Substitution Effect

Curvature: The size of the substitution effect depends on the curvature of

In practice, however, WTA for a product a consumer currently

• Non-market goods with limited substitutability (specifically,

Economists sometimes question whether Giffen goods actually exist

Rats were given limited “lever-pulls” to release liquid, and root

Findings imply quinine solution is a Giffen good for rats

6 Since chips and salsa are complements, when

1. Market demand is found by adding individual demand

2. The market demand curve

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