Individual and Market

Demand
Topics to be Discussed
• Individual Demand
• Income and Substitution Effects
• Market Demand
• Consumer Surplus
• Network Externalities
• Empirical Estimation of Demand

2
Individual Demand
• Price Changes

• Using the figures developed in the previous chapter, the

impact of a change in the price of food can be illustrated
using indifference curves

• For each price change, we can determine how much of the

good the individual would purchase given their budget lines
and indifference curves
3
Effect of a Price Change (Reduction in price of food here)

Clothing Assume:
• I = $20
10 • PC = $2
• PF = $2, $1, $0.50

6 A Each price leads to

U1 D different amounts of
5
B food purchased
4 U3

U2

Food (units
per month)
4 12 20
4
Effect of a Price Change
Clothing
The Price-Consumption
10
Curve traces out the
utility maximizing
6 A market basket for each
U1 D
price of food
5
B
4 U3

U2

Food (units
per month)
4 12 20
5
 Effect of a Price Change
Demand Schedule
• By changing prices and showing
what the consumer will purchase, P Q
we can create a demand schedule
and demand curve for the $2.00 4
individual
$1.00 12

• From the previous example: $0.50 20

6
Effect of a Price Change
Price
of Food
E Individual Demand relates the
$2.00
quantity of a good that a consumer
will buy to the price of that good.

G
$1.00
Demand Curve
$.50 H

Food (units
4 12 20 per month)
7
 Demand Curves – Important Properties
• The level of utility that can be attained changes as we move
along the curve

• At every point on the demand curve, the consumer is

maximizing utility by satisfying the condition that the MRS
of food for clothing equals the ratio of the prices of food and
clothing(MRSfc=Pf/Pc)

8
Effect of a Price Change
Price When the price falls,
of Food
A Pf /Pc & MRS also fall
$2.00

• A: Pf /Pc = 2/2 = 1 = MRS

B • B: Pf /Pc = 1/2 = .5 = MRS
$1.00
• C:Pf /Pc = .5/2 = .25 = MRS
$.50 C
Demand Curve
Food (units
4 12 20 per month)
9
Individual Demand
• Income Changes

• Using the figures developed in the previous chapter, the

impact of a change in the income can be illustrated using
indifference curves
• Changing income, with prices fixed, causes consumers to
change their market baskets

10
Effects of Income Changes
Clothing
(units per Assume: Pf = $1, Pc = $2
month)
I = $10, $20, $30

An increase in income, with

the prices fixed, causes
consumers to alter their choice
7 D of market basket.
U3
5 U2
B
3
A U1

Food (units
4 per month)
10 16
11
Problem

• How does the budget line change if consumer’s income

increases from 20 to 40 but the prices remain the same?
Solution
Individual Demand
• Income Changes
• The income-consumption curve traces out the
utility-maximizing combinations of food and clothing
associated with every income level

15
 Individual Demand
• Income Changes
• An increase in income shifts the budget line to the right,
increasing consumption along the income-consumption
curve

• Simultaneously, the increase in income shifts the demand

curve to the right

16
Effects of Income Changes
Clothing
(units per The Income Consumption Curve traces
month) out the utility maximizing market
basket for each income level

7
Income Consumption Curve
D
U3
5 U2
B
3
A U1

Food (units
4 per month)
10 16
17
Effects of Income Changes
Price
of An increase in income, from $10 to
food $20 to $30, with the prices fixed,
shifts the consumer’s demand curve
to the right as well.
E G H
$1.00

D3
D2
D1

Food (units
4 10 16 per month)
18
Individual Demand
• Income Changes
• When the income-consumption curve has a
positive slope:
• The quantity demanded increases with income
• The income elasticity of demand is positive
• The good is a normal good

19
Individual Demand
• Income Changes
• When the income-consumption curve has a
negative slope:
• The quantity demanded decreases with income
• The income elasticity of demand is negative
• The good is an inferior good

20
Inferior goods: example
Inter-city bus service is an example of an inferior good. This form of
transportation is cheaper than air or rail travel, but is more time-
consuming.
When money is constricted, traveling by bus becomes more acceptable,
but when money is more abundant than time, more rapid transport is
preferred. In some countries with less developed or poorly maintained
railways this is reversed: trains are slower and cheaper than buses, so
rail travel is an inferior good.
An Inferior Good
Income-Consumption Curve
Steak
(units per
Both hamburger and steak behave as a
month) normal good, between A and B...
C

10
U3
…but hamburger becomes an inferior
good when the income consumption curve
5 B bends backward between B and C.

U2
A
U1
Hamburger
30 (units per month)
5 10 20
22
Individual Demand
• Engel Curves
• Engel curves relate the quantity of 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
downward sloping

23
Engel Curves
Income 30
($ per
month)

20 Engel curves slope upward

for normal goods.

10

Food (units
4 8 12 16 per month)
24
Engel Curves
Income 30
($ per
month) Inferior

Engel curves are

20 backward bending
for inferior goods.
Normal

10

Food (units
4 8 12 16 per month)
25
Annual U.S. Household Consumer Expenditures

26
Substitutes & Complements
• Two goods are considered substitutes if an
increase (decrease) in the price of one(Px) leads
to an increase (decrease) in the quantity
demanded(Qy) of the other.
• Positive relation between Px and Qy

• Ex: movie tickets and video rentals

27
Substitutes & Complements
• Two goods are considered complements if an
increase (decrease) in the price of one leads to a
decrease (increase) in the quantity demanded of
the other
• Negative relation between Px and Qy

• Ex: gasoline and cars

28
Substitutes & Complements
• If two goods are independent, then a change
in the price of one good has no effect on the
quantity demanded of the other

• Ex: price of chicken and price of airplane

tickets

29
Substitutes & Complements
• If the price consumption curve is downward-
sloping, the two goods are considered substitutes

• If the price consumption curve is upward-sloping,

the two goods are considered complements

• They could be both

30
Income and Substitution Effects
• A change in the price of a good has two
effects:

• Substitution Effect
• Income Effect

31
Income and Substitution Effects
• Substitution Effect

• Relative price of a good changes when price changes

• Consumers will tend to buy more of the good that has

become relatively cheaper, and less of the good that is
relatively more expensive
32
Income and Substitution Effects
• Income Effect

• Consumers experience an increase in real

purchasing power when the price of one good
falls
• (Real income changes)

33
Income and Substitution Effects
• Substitution Effect
• The substitution effect is the change in an item’s
consumption associated with a change in the price
of the item, with the level of utility held constant
• When the price of an item declines, the substitution
effect always leads to an increase in the quantity
demanded of the good

34
Income and Substitution
Effects
• Income Effect
• The income effect is the change in an item’s
consumption brought about by the increase in
purchasing power, with the price of the item held
constant
• When a person’s income increases, the quantity
demanded for the product may increase or decrease

35
Income and Substitution Effects

• Income Effect
• Even with inferior goods, the income effect is
rarely large enough to outweigh the
substitution effect

36
 Substitution and Income Effects

When the price of a good decreases, two effects occur:

1) The good is cheaper compared to other goods; consumers will

substitute the cheaper good for more expensive goods
2) Consumers experience an increase in purchasing power similar to
an increase in income

37
Income effect
· Definition: As the price of x falls, all else constant,
purchasing power rises. This is called the income effect
of a change in price.

 The income effect may be positive (normal good) or

negative (inferior good).

38
 Substitution effect
As the price of x falls, all else constant, good x becomes cheaper relative to
good y. This change in relative prices alone and causes the consumer to adjust
his/ her consumption basket. This effect is called the substitution effect.

The substitution effect always is negative

Usually, a move along a demand curve will be
composed of both effects.
Graphically, these effects can be distinguished as follows…

39
Y (units) Normal Good: Income and Substitution Effects

BL2

BL1
Let Px decrease

A
• C
B
•
• U1
U2
BLd
Substitution

Income

0 XA XB XC X (units)
40
Y (units) Example: Inferior Good: Income and Substitution Effects

BL2
“X is an inferior good”

C
A • BL1

• U2

B BLd
• U1
Income
Substitution

0 XA XC XB X (units)
41
 Y (units) The Price Consumption Curve
The price consumption curve for good x plots all the utility
maximization points as the price of x changes. This reveals an
individual’s demand curve for good x.

10
Price consumption curve
• •
• PX = 1

PX = 4 PX = 2
0 XA=2 XB=10 XC=16 20 X (units)
42
 Example: Individual Demand Curve for X

The points found on the price consumption curve

produce the typically downward-sloping demand
PX curve we are familiar with.

PX = 4 •
PX = 2 • U increasing
PX = 1 •
X
XA=2 XB=10 XC=16
43
Income and Substitution Effects
• A Special Case: The Giffen Good
• Giffen goods: are the special type
of inferior goods in which the price
effect is negative.

• This rarely occurs and is of little practical interest

44
• Example - Bread is a giffen good for a poor person. Because
when there is an increase in the price of bread, the demand
of bread may also go up.
• Why?
• Price of bread increases.
• Now the real disposable income of the consumer has
decreased. (due to reduced purchasing power)
• As the consumer can now afford less units of other
expensive products like meat etc. He reduces the demand of
meat.
• To maintain the same level of nutrition, he reduces
consumption of meat, butter etc. but buys more units of
bread than before.

• So due to increase in price of bread, demand of bread

also increases.

• So, giffen goods are inferior goods with direct price

relation - price increases, demand increases.
Demand
• Demand comes from the behavior of buyers.

• The demand curve: the relationship between price and quantity demanded

• Quantity demanded – the amount of a good that buyers are willing and able to
purchase
• One important determinant of quantity demanded is the price of the product
• Quantity demanded is negatively related to price. This implies that the demand
curve is downward sloping
• 

Law of demand – the claim that, other things equal, the

quantity demanded of a good falls when the price of the
good rises.
• Demand function
• q = 450 − 3p
• where p is price and q is quantity demanded. Thus the expected
quantity demanded can be predicted for any given value of p, e.g.
• if p = 60 then
• q = 450 − 3(60)
• = 450 − 180
• = 270
• Qd = 120 − 2P
• Calculate Qd when P=10, 45

I. Qd = 120 − 2(10) = 120 − 20 = 100

II. Qd = 120 − 2(45) = 120 − 90 = 30
 Demand Schedule
Quantity
Price
of lattes
• A table that shows the relationship of lattes
demanded
between the price of a good and the
$0.00 16
quantity demanded
1.00 14
• Example: Helen’s demand for lattes.
2.00 12
• Notice that Helen’s preferences obey 3.00 10
the Law of Demand.
4.00 8
5.00 6
6.00 4
 Price of
Demand Curve
Lattes
$6.00 • A graph of the relationship
$5.00 between the price of a good and
the quantity demanded
$4.00 • Price is generally drawn on the
$3.00 vertical axis
$2.00 • Quantity demanded is
represented on the horizontal axis
$1.00
$0.00
Quantity of
0 5 10 15 Lattes
 Helen’s Demand Schedule & Curve
Price of Quantity
Price
Lattes of lattes
of lattes
demanded
$6.00
$0.00 16
$5.00
1.00 14
$4.00 2.00 12
$3.00 3.00 10
$2.00 4.00 8
5.00 6
$1.00
6.00 4
$0.00
Quantity of
0 5 10 15 Lattes
Why the demand curve slopes downward?

• What causes the inverse relationship between price and quantity demanded? Move
along the line/curve

• Law of Diminishing Marginal Utility

• Income Effect – a lower price has the effect of increasing money income => buy
more of other things

• Substitution Effect–a lower price causes people to switch to the purchase of the
“better deal”
• Common sense – buy more if price is lower
 Market Demand Versus Individual Demand
• The market demand is the sum of all of the individual demands for a
particular good or service

• The demand curves are summed horizontally – meaning that the

quantities demanded are added up for each level of price

• The market demand curve shows how the total quantity demanded of a
good varies with the price of the good, holding constant all other factors
that affect how much consumers want to buy
 Market Demand versus Individual Demand
• Suppose Helen and Ken are the only two buyers in the Latte
market. (Qd = quantity demanded)

Price Helen’s Qd Ken’s Qd Market Qd

$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 The Market Demand Curve for Lattes
P P Qd (Market)
$6.00 $0.00 24
$5.00 1.00 21
$4.00 2.00 18
3.00 15
$3.00
4.00 12
$2.00 5.00 9
$1.00 6.00 6
$0.00 Q
0 5 10 15 20 25
 Shifts in the Demand Curve
• The demand curve shows how much consumers want to buy at
any price, holding constant the many other factors that influence
buying decisions

• If any of these other factors change, the demand curve will shift
• An increase in demand can be represented by a shift of the demand
curve to the right
• A decrease in demand can be represented by a shift of the demand
curve to the left
 Shifts in the Demand Curve
• Income
• The relationship between income and quantity demanded depends on what type
of good the product is
• Normal good – a good for which, other things equal, an increase in income
leads to a increase in demand
• Demand for a normal good is positively related to income.
• Inferior good – a good for which, other things equal, an increase in income
leads to a decrease in demand
• Demand for an inferior good is negatively related to income.
 Shifts in the Demand Curve
• Prices of related goods
• Substitutes – two goods for which an increase in the price of one good leads to an
increase in the demand for the other
• Example: hot dogs and hamburgers.
An increase in the price of hot dogs increases demand for hamburgers, shifting
hamburger demand curve to the right.
• Other examples: Coke and Pepsi, laptops and desktop computers, compact
discs and music downloads
• Complements – two goods for which an increase in the price of
one good leads to a decrease in the demand for the other

• Example: computers and software.

If price of computers rises, people buy fewer computers, and
therefore less software. Software demand curve shifts left.
• Other examples: college tuition and textbooks, bagels and
cream cheese, eggs and bacon
Shifts in the Demand Curve
• Tastes
• Example:
The Atkins diet became popular in the ’90s, caused an increase in demand for eggs,
shifted the egg demand curve to the right.
• Expectations – future income or future prices
• Examples:
• If people expect their incomes to rise, their demand for meals at expensive
restaurants may increase now.
• If the economy turns bad and people worry about their future job security,
demand for new autos may fall now.
• Number of buyers
• An increase in the number of buyers causes
an increase in quantity demanded at each price,
which shifts the demand curve to the right.
 Demand Curve Shifters: # of buyers
P Suppose the number of buyers
$6.00 increases.
Then, at each price, quantity
$5.00 demanded will increase
$4.00 (by 5 in this example).

$3.00
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30
Elasticity
 A scenario…

You
You design
design websites
websites for
for local
local businesses.
businesses.
You
You charge
charge $200
$200 per
per website,
website, and
and currently
currently sell
sell 12
12 websites
websites per
per
month.
month.
Your
Your costs
costs are
are rising
rising (including
(including the
the opp.
opp. cost
cost ofof your
your time),
time), so
so you’re
you’re
thinking
thinking of
of raising
raising the
the price
price to
to $250.
$250.
The
The law
law of
of demand
demand says
says that
that you
you won’t
won’t sell
sell as
as many
many websites
websites ifif you
you
raise
raise your
your price.
price.
How
How many
many fewer
fewer websites?
websites?
How
How much
much will
will your
your revenue
revenue fall,
fall, or
or might
might itit increase?
increase?
Elasticity

• Basic idea: Elasticity measures how much one variable

responds to changes in another variable.
• One type of elasticity measures how much demand for your
websites will fall if you raise your price.
• Definition:
Elasticity is a numerical measure of the responsiveness
of Qd or Qs to one of its determinants.
Price Elasticity of Demand
Price elasticity of Percentage change in Qd
=
demand Percentage change in P

• Price elasticity of demand measures how much Qd responds to a

change in P.

 Loosely speaking, it measures the price-sensitivity of

buyers’ demand.
 Price Elasticity of Demand
Price elasticity of Percentage change in Qd
=
demand Percentage change in P
P
Example:
P rises by
Price elasticity of P2
10%
demand equals P1
D
Q
15% Q2 Q1
= 1.5 Q falls by
10%
15%
 Price Elasticity of Demand

Price elasticity of Percentage change in Qd

=
demand Percentage change in P
P
Along
Along aa D
D curve,
curve, PP and
and QQ move
move
in P2
in opposite
opposite directions,
directions, which
which
P1
would
would make
make price
price elasticity
elasticity
D
negative.
negative.
Q
Q2 Q1
Calculating Percentage Changes
Standard method of computing the percentage
(%) change:
Demand for your
websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12
Calculating Percentage Changes
Problem:
The standard method gives different answers
Demand for your depending on where you start.
websites
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%, elasticity = 50/20
Q = 2.50
8 12
Calculating Percentage Changes
• So, we instead use the midpoint method:

end value – start value

x 100%
midpoint
 The midpoint is the number halfway between the start & end values, also
the average of those values.
 It doesn’t matter which value you use as the “start” and which as the
“end” – you get the same answer either way!
Calculating Percentage Changes
• Using the midpoint method, the % change in P equals

$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
12 – 8
x 100% = 40.0%
10
 The price elasticity of demand equals
40/22.2 = 1.8
• If the price rises by 3 %, the quantity
demanded falls by 1.5 %. Calculate the price
elasticity of demand.
A C T I V E L E A R N I N G 1:
Calculate an elasticity

Use the following information to calculate the

price elasticity of demand for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

77
A C T I V E L E A R N I N G 1:
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals

50%
= 2.0
25%

78
What determines price elasticity?
To learn the determinants of price elasticity, we look at a series of examples.
Each compares two common goods.
In each example:
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent) has the highest price elasticity of
demand. Which good is it? Why?
• What lesson does the example teach us about the determinants of the price elasticity of
demand?
EXAMPLE 1:
Rice Krispies vs. Sunscreen
• The prices of both of these goods rise by 20%. For which good
does Qd drop the most? Why?
• Rice Krispies (Breakfast cereal) has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula), so buyers can easily
switch if the price rises.
• Sunscreen has no close substitutes, so consumers would
probably not buy much less if its price rises.
• Lesson: Price elasticity is higher when close substitutes are
available.
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
• The prices of both goods rise by 20%. For which good does Qd
drop the most? Why?
• For a narrowly defined good such as blue jeans, there are
many substitutes (khakis, shorts).
• There are fewer substitutes available for broadly defined
goods.
(No substitute for clothing)
• Lesson: Price elasticity is higher for narrowly defined goods
than broadly defined ones.
EXAMPLE 3:
Insulin vs. Caribbean Cruises
• The prices of both of these goods rise by 20%. For which good
does Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in
demand.
• A cruise is a luxury. If the price rises, some people will
forego it.
• Lesson: Price elasticity is higher for luxuries than for
necessities.
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in the Long Run
• The price of gasoline rises 20%. Does Qd drop more in the short
run or the long run? Why?
• There’s not much people can do in the short run, other than
ride the bus or carpool.
• In the long run, people can buy smaller cars or live closer to
where they work.
• Lesson: Price elasticity is higher in the long run than the
short run.
The Determinants of Price Elasticity:
A Summary

The
The price
price elasticity
elasticity of
of demand
demand depends
depends on:
on:
 the
the extent
extent to
to which
which close
close substitutes
substitutes are
are available
available
 whether
whether the
the good
good is
is aa necessity
necessity or
or aa luxury
luxury
 how
how broadly
broadly oror narrowly
narrowly the
the good
good is
is defined
defined
 the
the time
time horizon:
horizon: elasticity
elasticity is
is higher
higher in
in the
the long
long run
run than
than
the
the short
short run.
run.
The Variety of Demand Curves
• Economists classify demand curves according to their elasticity.
• The price elasticity of demand is closely related to the slope of the
demand curve.
• Rule of thumb:
The flatter the demand curve, the higher the elasticity.
The steeper the demand curve, the smaller the elasticity.
• The next 5 slides present the different classifications, from least to most
elastic.
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’ price sensitivity:
0 P2

P falls by Q
Elasticity: 10% Q1
0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls by Q
Elasticity: 10% Q1 Q2
<1
Q rises less than
10%
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls by Q
Elasticity: 10% Q1 Q2
1
Q rises by 10%
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls by Q
Elasticity: 10% Q1 Q2
>1
Q rises more than
10%
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes by 0% Q
Elasticity: Q1 Q2
infinity
Q changes
by any %
Elasticity of a Linear Demand Curve
P The slope
of a linear demand
$30 curve is constant,
but its elasticity
20 is not.

10

$0 Q
0 20 40 60
Elasticity of a Linear Demand Curve
P The slope
200% of a linear demand
$30 E= = 5.0 curve is constant,
40%
but its elasticity
67% is not.
20 E= = 1.0
67%
40%
10 E= = 0.2
200%

$0 Q
0 20 40 60
Price Elasticity and Total Revenue
•  Continuing our scenario, if you raise your price from $200 to
$250, would your revenue rise or fall?

• A price increase has two effects on revenue:

• Higher P means more revenue on each unit you sell.
• But you sell fewer units (lower Q), due to Law of Demand.
• Which of these two effects is bigger?
It depends on the price elasticity of demand.
Price Elasticity and Total Revenue
Price elasticity of Percentage change in Q
=
demand Percentage change in P

Revenue = P x Q
• If demand is elastic, then
price elasticity of demand > 1
% change in Q > % change in P
• The fall in revenue from lower Q is greater than the increase in revenue
from higher P, so revenue falls.
Price Elasticity and Total Revenue Demand for your
websites
Elastic demand
(elasticity = 1.8) increased revenue
P lost revenue
due to higher P due to lower
If P = $200, Q = 12 and
Q
revenue = $2400. $250
$200
If P = $250, D
Q = 8 and
revenue = $2000.
Q
When D is elastic, a price 8 12
increase causes revenue to fall.
 Price Elasticity and Total Revenue
Price elasticity of Percentage change in Q
=
demand Percentage change in P

Revenue = P x Q
• If demand is inelastic, then
price elasticity of demand < 1
% change in Q < % change in P
• The fall in revenue from lower Q is smaller than the increase in revenue from
higher P, so revenue rises.
• In our example, suppose that Q only falls to 10 (instead of 8) when you raise
your price to $250 the revenue would increase by 2500.
Price Elasticity and Total Revenue
Demand for your
Now, demand is inelastic: websites
increased revenue
elasticity = 0.82 due to higher P
P lost revenue
If P = $200, due to lower
Q
Q = 12 and revenue =
$250
$2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, a price Q
10 12
increase
causes revenue to rise.
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%. Does
total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury cruise

falls 20%. Does luxury cruise companies’ total revenue
rise or fall?

98
A C T I V E L E A R N I N G 2:
Answers

A. Pharmacies raise the price of insulin by 10%. Does

total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less than 10%, so
expenditure rises.

99
A C T I V E L E A R N I N G 2:
Answers
B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue rise or fall?
Revenue = P x Q
The fall in P reduces revenue, but Q increases, which
increases revenue. Which effect is bigger?
Since demand is elastic, Q will increase more than 20%, so
revenue rises.

100
Calculate price elasticity and total revenue
Calculate Elasticity of a Linear Demand Curve
Elasticity of a Linear Demand Curve
Price Elasticity and Consumer Expenditure

104
Income Elasticity of Demand

• Income elasticity of demand measures how much the

quantity demanded of a good responds to a change in
consumers’ income.
• It is computed as the percentage change in the quantity
demanded divided by the percentage change in income.
Other Elasticities
• The income elasticity of demand measures the response of Qd to a
change in consumer income.

Income elasticity of Percent change in Qd

=
demand Percent change in income

 An increase in income causes an increase in demand for a normal

good.
 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.
Income Elasticity and types of goods
• Types of Goods
• Normal Goods
• Inferior Goods

• Higher income raises the quantity demanded for normal

goods but lowers the quantity demanded for inferior
goods.
Income Elasticity
• Goods consumers regard as necessities tend to be income
inelastic
• Examples include food, fuel, clothing, utilities, and medical
services.
• Goods consumers regard as luxuries tend to be income
elastic.
• Examples include sports cars, furs, and expensive foods.
The income elasticities of demand of two goods, A and B, are
as follows:
• Good A: + 3.0
• Good B: - 0.2
Now income rises by 5 %. By how much quantities demanded
of A and B will change?
• Which type of goods can be observed assuming the
following income elasticities of demand?
• Good X: + 0.5
• Good Y: + 2.6
• Good Z: - 0.4
• Good X: Normal good, necessity
• Good Y: Normal good, luxury good
• Good Z: Inferior good
Other Elasticities
• The cross-price elasticity of demand measures the response of demand
for one good to changes in the price of another good.

Cross-price elasticity % change in Qd for good 1

=
of demand % change in price of good 2

 For substitutes, cross-price elasticity > 0 , (+)

E.g., an increase in price of beef causes an increase in demand for
chicken.
 For complements, cross-price elasticity < 0 (-)
E.g., an increase in price of computers causes decrease in demand for
software.
• Elasticity measures the responsiveness of Qd or Qs to one of its
determinants.
• Price elasticity of demand equals percentage change Qd in
divided by percentage change in P. When it’s less than one,
demand is “inelastic.” When greater than one, demand is
“elastic.”
• When demand is inelastic, total revenue rises when price rises.
When demand is elastic, total revenue falls when price rises.
• Demand is less elastic in the short run, for necessities, for
broadly defined goods, or for goods with few close substitutes.

• Price elasticity of supply equals percentage change in Qs divided

by percentage change in P. When it’s less than one, supply is
“inelastic.” When greater than one, supply is “elastic.”

• Price elasticity of supply is greater in the long run than in the

short run.
• The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers’ incomes.
• The cross-price elasticity of demand measures how
much demand for one good responds to changes in
the price of another good.
Consumer Surplus
CONSUMER SURPLUS

• Willingness to pay is the maximum amount that a

buyer will pay for a good.
• It measures how much the buyer values the good or
service.
• Consumer surplus is the buyer’s willingness to pay for
a good minus the amount the buyer actually pays for it.
CONSUMER SURPLUS
• The market demand curve depicts the various quantities
that buyers would be willing and able to purchase at
different prices.

• The difference between the maximum price a consumer

is (or would be) willing to pay and the price she actually
has to pay is that consumer’s surplus.
The Demand Schedule and the Demand
Curve
 Figure 1 The Demand Schedule and the Demand Curve

Price of
Album

$100 John ’ s willingness to pay

80 Paul ’s willingness to pay

70 George ’s willingness to pay

50 Ringo ’s willingness to pay

Demand

0 1 2 3 4 Quantity of
Albums
Figure 2 Measuring Consumer Surplus with the Demand Curve

(a) Price = $80

Price of
Album

$100
John ’s consumer surplus ($20)

80

70

50

Demand

0 1 2 3 4

Quantity of
Albums
Figure 2 Measuring Consumer Surplus with the Demand Curve

(b) Price = $70

Price of
Album
$100
John ’s consumer surplus ($30)

80
Paul ’s consumer
70 surplus ($10)

Total
50 consumer
surplus ($40)

Demand

0 1 2 3 4 Quantity of
Albums
Using the Demand Curve to Measure Consumer Surplus

• The area below the demand curve and above the

price measures the consumer surplus in the
market.
Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price

Price
P A

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity
Figure 3 How the Price Affects Consumer Surplus

(b) Consumer Surplus at PriceP2

Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
What Does Consumer Surplus Measure?
• Consumer surplus, the amount that buyers are willing to pay
for a good minus the amount they actually pay for it,
measures the benefit that buyers receive from a good as the
buyers themselves perceive it.
• The “extra” value or utility a consumer gets when the good’s
market price is below what she would be willing to pay for
the good.
Consumer Surplus
• Consumers buy goods because it makes them
better off

• Consumer Surplus measures how much better off

they are

128
Network Externalities
• Up to this point we have assumed that people’s
demands for a good are independent of one
another
• For some goods, one person’s demand also
depends on the demands of other people

129
Network Externalities

• If this is the case, a network externality

exists
• Network externalities can be positive or
negative

130
Network Externalities
• A positive network externality exists if the quantity
of a good demanded by a consumer increases in
response to an increase in purchases by other
consumers
• Negative network externalities are just the opposite

131
Network Externalities
• The Bandwagon Effect
• This is the desire to be in style, to have a good because almost
everyone else has it, or to indulge in a fad
• This is the major objective of marketing and advertising
campaigns (e.g. toys, clothing)
• Positive network externality in which a consumer wishes to
possess a good in part because others do

132
Positive Network
Externality: Bandwagon Effect
Price D20 D40 D60 D80 D100
($ per
unit) When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right.

Quantity
20 40 60 80 100 (thousands per month)
133
Positive Network
Externality: Bandwagon Effect
Price D20 D40 D60 D80 D100 The market demand
($ per curve is found by joining
unit)
the points on the individual
demand curves. It is relatively
more elastic.

Demand

Quantity
20 40 60 80 100 (thousands per month)
134
Positive Network
Externality: Bandwagon Effect
Price D40 D60 D80 D100 But as
Suppose themore
pricepeople
falls buy
D20
($ per from the
$30 good,
to $20.it If
becomes
there
unit) stylish
were no to own iteffect,
bandwagon and
the quantity
quantity demanded demanded
would
increases
only increase further.
to 48,000
$30

Demand
$20 Bandwagon
Pure Price
Effect
Effect

Quantity
20 40 48 60 80 100 (thousands per month)
135
Network Externalities
• The Snob Effect
• If the network externality is negative, a snob effect exists
• The snob effect refers to the desire to own exclusive or unique goods
• The quantity demanded of a “snob” good is higher the fewer the
people who own it

136
Network Externality: Snob Effect
Price
($ per Originally demand is D2,
unit) Demand
when consumers think 2,000
$30,000 people have bought a good.

However, if consumers think 4,000

people have bought the good,
demand shifts from D2 to D6 and its
snob value has been reduced.
$15,000

D2
Pure Price Effect
D4
D6
D8
Quantity (thousands
2 4 6 8 14 per month)

137
Network Externality: Snob Effect
Price
($ per The demand is less elastic and
unit) Demand as a snob good its value is greatly
reduced if more people own
$30,000 it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.

Net Effect
Snob Effect

$15,000

D2
Pure Price Effect
D4
D6
D8
Quantity (thousands
2 4 6 8 14 per month)

138
Empirical Estimation of Demand
• The most direct way to obtain information about demand is
through interviews where consumers are asked how much of
a product they would be willing to buy at a given price
• Problem is that consumers may lack information or interest,
or be misled by the interviewer
• In direct marketing experiments, actual sales offers are posed
to potential customers and the responses of customers are
observed

139
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

140
Demand Data for Raspberries

141
Empirical Estimation of Demand
••  
Assuming only price determines demand:

142
Estimating Demand

Price 25
D represents demand
if only P determines
20 demand and then from
the data: Q=28.2-1.00P

15
d1
10

5 d2 D
d3

0 5 10 15 20 25 Quantity
143
Estimating Demand – Changes in Income
Price
25 d1, d2, d3 represent the demand for each
income level. Including income in the
demand equation: Q = a - bP + cI or Q =
20 8.08 - .49P + .81I

15
d1
10

5 d2 D
d3

0 5 10 15 20 25 Quantity
144
Empirical Estimation of Demand
• Estimating Elasticities
• For the demand equation: Q = a - bP
• Elasticity:

EP  (Q / P )( P / Q)  b( P / Q )

145
Empirical Estimation of Demand
• Assuming: Price and income elasticity are
constant
• The isoelastic demand =

log(Q)  a  b log(P)  c log(I )

The slope, -b = price elasticity of demand
Constant, c = income elasticity of demand

146
Empirical Estimation of Demand
• Using the Raspberry data:

log(Q)  0.81  2.4 log(P)  1.46 log(I )

Price elasticity = -0.24 (Inelastic)

Income elasticity = 1.46

147
Empirical Estimation of Demand
Complements and Substitutes

log(Q)  a  b log(P )  b2 log P2  c log(I )

• Substitutes: b2 is positive
• Complements: b2 is negative

148
The Demand for Ready-to-Eat Cereal
• Are Grape Nuts and Spoon Size Shredded Wheat good substitutes?
• Estimated demand for Grape Nuts (GN)

log(QGN )  1.998  2.085 log( PGN )  0.62 log( I )  0.14 log( PSW )

Price elasticity = -2.0

Income elasticity = 0.62
Cross elasticity = 0.14

149