CHAPTER 4 OUTLINE,4.1 Individual Demand 4.2 Income and Substitution Effects 4.3 Market Demand 4.4 Consumer Surplus 4.5 Network Externalities 4.6 Empirical Estimation of Demand,INDIVIDUAL DEMAND,Price Changes,Effect of Price Changes,A reduction in the price of food, with income and the price of clothing fixed, causes this consumer to choose a different market basket. In (a), the baskets that maximize utility for various prices of food (point A, $2; B, $1; D, $0.50) trace out the price-consumption curve. Part (b) gives the demand curve, which relates the price of food to the quantity demanded. (Points E, G, and H correspond to points A, B, and D, respectively).,Figure 4.1,INDIVIDUAL DEMAND,The Individual Demand Curve,price-consumption curve Curve tracing the utility-maximizing combinations of two goods as the price of one changes.,individual demand curve Curve relating the quantity of a good that a single consumer will buy to its price.,INDIVIDUAL DEMAND,Income Changes,Effect of Income Changes,An increase in income, with the prices of all goods fixed, causes consumers to alter their choice of market baskets. In part (a), the baskets that maximize consumer satisfaction for various incomes (point A, $10; B, $20; D, $30) trace out the income-consumption curve. The shift to the right of the demand curve in response to the increases in income is shown in part (b). (Points E, G, and H correspond to points A, B, and D, respectively.),Figure 4.2,INDIVIDUAL DEMAND,Normal versus Inferior Goods,An Inferior Good,An increase in a persons income can lead to less consumption of one of the two goods being purchased. Here, hamburger, though a normal good between A and B, becomes an inferior good when the income-consumption curve bends backward between B and C.,Figure 4.3,INDIVIDUAL DEMAND,Engel Curves,Engel Curves,Engel curves relate the quantity of a good consumed to income. In (a), food is a normal good and the Engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month.,Figure 4.4,Engel curve Curve relating the quantity of a good consumed to income.,INDIVIDUAL DEMAND,If the market price were held constant, we would expect to see an increase in the quantity demanded as a result of consumers higher incomes. Because this increase would occur no matter what the market price, the result would be a shift to the right of the entire demand curve.,INDIVIDUAL DEMAND,TABLE 4.1 Annual U.S. Household Consumer Expenditures,INCOME GROUP (2005$),ExpendituresLess than10,000-20,000-30,000-40,000-50,00070,000 ($) on:$10,00019,99929,99939,99949,99969,999and above,Entertainment84494711911677193324024542 Owned Dwelling42724716570167767771897214763 Rented Dwelling2672277929802977281822551379 Heath Care1108187422412361277827463812 Food2901324239424552523465709247 Clothing86188411061472145019613245,Source: U.S. Department of Labor, Bureau of Labor Statistics, “Consumer Expenditure Survey, Annual Report 2005.”,INDIVIDUAL DEMAND,Engel Curves for U.S. Consumers,Average per-household expenditures on rented dwellings, health care, and entertainment are plotted as functions of annual income. Health care and entertainment are normal goods, as expenditures increase with income. Rental housing, however, is an inferior good for incomes above $35,000.,Figure 4.5,INDIVIDUAL DEMAND,Substitutes and Complements,Recall that: Two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other. Two goods are complements if an increase in the price of one good leads to a decrease in the quantity demanded of the other. Two goods are independent if a change in the price of one good has no effect on the quantity demanded of the other.,INCOME AND SUBSTITUTION EFFECTS,A fall in the price of a good has two effects: Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power.,INCOME AND SUBSTITUTION EFFECTS,Income and Substitution Effects: Normal Good,A decrease in the price of food has both an income effect and a substitution effect. The consumer is initially at A, on budget line RS. When the price of food falls, consumption increases by F1F2 as the consumer moves to B. The substitution effect F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Food is a normal good because the income effect EF2 is positive.,Figure 4.6,INCOME AND SUBSTITUTION EFFECTS,Substitution Effect,substitution effect Change in consumption of a good associated with a change in its price, with the level of utility held constant.,Income Effect,income effect Change in consumpt