CHAPTER 4:

INDIVIDUAL & MARKET

DEMAND

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4.1 Individual Demand

4.2 Income & Substitution Effects

4.3 Market Demand

4.4 Consumer Surplus CHAPTER 4

4.5 Network Externalities
OUTLINE

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 4.1 INDIVIDUAL DEMAND

1. Effect of Price Changes

A decrease in the price of food, with Price-consumption curve

income and the price of clothing fixed,
causes the consumer to choose a
different market basket.

In (a), the baskets that maximize

utility for various prices of food (point
A, Pfood=$2; point B, Pfood=$1; point
D, Pfood =$0.50) trace out the price-
consumption curve.
Individual demand 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).
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● Price-consumption curve

Curve tracing the utility-maximizing

combinations of two goods (i.e., the optimal
basket) as the price of one good changes.

● Individual demand curve

Curve relating the quantity of a good that a

single consumer will buy to its price.

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 When the price of food decreases:

1. The consumption of food will increase.

2. The consumption of clothing may increase or decrease.

3. The utility increases and MRS decreases along the individual

demand curve.

4. At every point along the individual demand curve, the QD of

food is the utility maximizing amount.

5. Over the downward sloping portion of the price consumption

curve (i.e. A to B), clothing and food are substitutes. Over the
upward sloping portion (B to D), clothing and food are
complements.

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2. Effect of Income Changes

An increase in income, holding

constant the prices of all goods, Income consumption curve
causes consumers to change their
choice of market baskets.

In part (a), the baskets that

maximize utilities for various
incomes (point A, income=$10;
point B, income=$20; point D,
income=$30) trace out the
income-consumption curve.

Demand curve shifts rightward in

response to the increases in
income, shown in (b). (Points E, G,
and H correspond to points A, B,
and D, respectively.)
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 Normal versus Inferior Goods

An increase in one’s
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.

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 ● Engel curve

Curve relating the quantity of a good consumed to income.

In (a), food is a normal good, so

the Engel curve is upward
sloping.

In (b), hamburger is a normal

good for income less than $20
per month and an inferior good
for income greater than $20 per
month.

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EXAMPLE 4.1 CONSUMER EXPENDITURES
IN THE UNITED STATES (1 of 2)
We can derive Engel curves for groups of
consumers. This information is particularly
useful if we want to see how consumer
spending varies among different income
groups.

TABLE 4.1: ANNUAL U.S. HOUSEHOLD CONSUMER EXPENDITURES

INCOME GROUP
EXPENDITURES ($) LESS THAN 10,000– 20,000– 30,000– 40,000– 50,000– 70,000 AND
ON: $10,000 19,999 29,999 39,999 49,999 69,999 ABOVE

Entertainment 1,038 1,165 1,407 1,969 2,131 2,548 4,655

Owned Dwelling 1,770 2,134 2,795 3,581 4,198 5,556 11,606

Rented Dwelling 3,919 3,657 4,054 3,878 4,273 3,812 3,072

Health Care 1,434 2,319 3,124 3,539 3,709 4,702 6,417

Food 3,466 3,706 4,432 5,194 5,936 6,486 10,116

Clothing 798 766 960 1,321 1,518 1,602 2,928

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EXAMPLE 4.1 CONSUMER EXPENDITURES IN
THE UNITED STATES (2 of 2)

FIGURE 4.5

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 $40,000.
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 Question 1 & 2
As we move downward along a demand curve for apples,
A) consumer well-being decreases.
B) the marginal utility of apples decreases.
C) the marginal utility of apples increases.
D) Both A and B are true.
E) Both A and C are true.

An individual demand curve can be derived from the ________

curve.
A) price-consumption
B) price-income
C) income-substitution
D) income-consumption
E) Engel
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 Question 3 & 4
Which of the following claims is true at each point along a
price-consumption curve?
A) Utility is maximized but income is not all spent.
B) All income is spent, but utility is not maximized.
C) Utility is maximized, and all income is spent.
D) The level of utility is constant.

Which of the following is true regarding income along a price-

consumption curve?
A) Income is increasing.
B) Income is decreasing.
C) Income is constant.
D) The level of income depends on the level of utility.
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 Question 5 & 6
The income-consumption curve
A) illustrates the combinations of incomes needed with various levels
of consumption of a good.
B) is another name for income-demand curve.
C) illustrates the utility-maximizing combinations of goods associated
with every income level.
D) shows the utility-maximizing quantity of some good (on the
horizontal axis) as a function of income (on the vertical axis).

When the income-consumption curve has a positive slope

throughout its entire length, we can conclude that
A) both goods are inferior.
B) both goods are normal.
C) the good on the vertical (y) axis is inferior.
D) the good on the horizontal (x) axis is inferior.

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Substitutes and Complements

Recall that:

Two goods are substitutes if an increase in the price of one

leads to an increase in the QD of the other.

Two goods are complements if an increase in the price of one

good leads to a decrease in the QD of the other.

Two goods are independent if a change in the price of one

good has no effect on the QD of the other.

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4.2 INCOME AND SUBSTITUTION EFFECTS

A fall in the price of a good has two effects:

1. Consumers will tend to buy more of the good that has

become cheaper and less of those goods that are now
relatively more expensive.

2. Because one of the goods is now cheaper, consumers

enjoy an increase in real purchasing power.

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 Income and Substitution Effects: case (1) Normal Good

When Pfood decreases, the optimal

basket moves from A to B. The Normal
resulting change in food purchased Good
can be broken down into 2 effects:

The substitution effect F1E (associated

with a move from A to D): change in
consumption of a good associated with Decomposition Basket
a change in price, keeping the utility
level constant.

The income effect EF2 (associated

with a move from D to B): an increase
in purchasing power, keeping relative
prices constant

Food is a normal good because the

income effect EF2 is positive. 16
Substitution Effect (S.E.)
● Change in consumption of a good
associated with a change in its price, with
the level of utility held constant.

Income Effect (I.E.)

● Change in consumption of a good resulting
from an increase in purchasing power, with
relative prices held constant.

The total effect (T.E.) of a change in price is given theoretically

by the sum of the substitution effect and the income effect:

Total Effect = Substitution Effect + Income Effect

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 Income and Substitution Effects: case (2) Inferior Good

With a decrease in Pfood, the

Inferior
consumer moves from A to B.

Substitution effect is F1E (associated Good

with a move from A to D).

Income effect is EF2 (associated with

a move from D to B).

In this case, food is an inferior good

because the I.E. is negative.
However, because the S.E. exceeds
the I.E., the decrease in the price of
food leads to an increase in the
quantity of food demanded (i.e.
T.E.>0).

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 A Special Case: The Giffen Good

● Giffen good Good whose demand curve slopes upward

because the (negative) income effect is larger than the
substitution effect.
When food is an inferior good, and Giffen
when the income effect is large
enough to dominate the
Good
substitution effect, the demand
curve will be upward-sloping.

The consumer is initially at point A,

but, after the price of food falls,
moves to B and consumes less
food.

Because the income effect EF2 is

larger than the substitution effect 𝐹2 𝐹1 E
F1E, the decrease in the price of
food leads to a lower quantity of
food demanded. 19
 Question 7
Based on the diagram below it can be inferred that:
A) hot dogs are a normal good for all levels of income.
B) hot dogs are an inferior good, but not a Giffen good, for all
levels of income.
C) hot dogs are a Giffen good for all levels of income.
D) hot dogs are an inferior good for low levels of income, but at
higher levels of income become a normal good.
E) none of the above

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 Question 8
Use the following two statements in answering this question:

I. All Giffen goods are inferior goods.

II. All inferior goods are Giffen goods.
A) I and II are true.
B) I is true, and II is false.
C) I is false, and II true.
D) I and II are false.

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 Question 9
A consumer's original utility maximizing market basket of goods is
shown as point A. Following a price change, the consumer's
utility maximizing market basket changes is at point B.
The substitution effect of the price change in food on the quantity
of food purchased is___, The income effect of the price change in
food on the quantity of food purchased is___, food is___.

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4.3 MARKET DEMAND
● market demand curve Curve relating the quantity of a good
that all consumers in a market will buy to its price.

From Individual to Market Demand

TABLE 4.2 DETERMINING THE MARKET DEMAND CURVE
(1) (2) (3) (4) (5)
PRICE INDIVIDUAL A INDIVIDUAL B INDIVIDUAL C MARKET
($) (UNITS) (UNITS) (UNITS) UNITS
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6

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 From Individual to Market Demand
Summing to Obtain a Market Demand Curve

The market demand curve is obtained

by summing individual demand curves
DA, DB, and DC.

At each price, the quantity of coffee

demanded by the market is the sum of
the quantities demanded by each
consumer.

E.g. when P= $4, the quantity

demanded by the market (11 units) is
the sum of the quantity demanded by
A (no units), B (4 units), and C (7
units).

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From Individual to Market Demand
Two points should be noted as a result of this analysis:
1. The market demand curve will shift to the right as more
consumers enter the market.
2. Factors that influence the demands of many consumers
will also affect market demand.

The aggregation of individual demands into market demands

becomes important in practice when market demands are
built up from the demands of different demographic groups or
from consumers located in different areas.

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Elasticity of Demand
Denoting the quantity of a good by Q and its price by P, the price
elasticity of demand is

(4.1)

Inelastic Demand
When demand is inelastic (i.e. Ep is less than one in absolute value),
the quantity demanded is relatively unresponsive to changes in price.
As a result, total expenditure on the product increases when the price
increases.

Elastic Demand
When demand is elastic (Ep is greater than one in absolute value),
total expenditure on the product decreases as the price goes up.
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 Isoelastic Demand

● isoelastic demand curve Demand curve with a constant price

elasticity.

When the price

elasticity of demand is
−1.0 at every price,
Unit-Elastic Demand Curve
the total expenditure
is constant along the
demand curve D.

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PRICE ELASTICITY AND CONSUMER EXPENDITURES

DEMAND IF PRICE INCREASES, IF PRICE DECREASES,

EXPENDITURES EXPENDITURES

Inelastic Increase Decrease

Unit elastic Are unchanged Are unchanged

Elastic Decrease Increase

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EXAMPLE 4.3 THE AGGREGATE
DEMAND FOR WHEAT (1 of 2)
Domestic demand for wheat is given by the equation

QDD =1430− 55P

where QDD is the number of bushels (in millions) demanded domestically, and P is the price
in dollars per bushel.

Export demand is given by

QDE =1470 − 70P
where QDE is the number of bushels (in millions) demanded from abroad.

To obtain the world demand for wheat, we set the left side of each demand equation equal
to the quantity of wheat. We then add the right side of the equations, obtaining

QDD +QDE = (1430 - 55P ) + (1470 - 70P ) = 2900 -125P

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EXAMPLE 4.3 THE AGGREGATE DEMAND
FOR WHEAT (2 of 2)
FIGURE 4.12

THE AGGREGATE DEMAND FOR WHEAT

The total world demand for wheat is the

horizontal sum of the domestic demand
AB and the export demand CD.

Even though each individual demand curve is

linear, the market demand curve is kinked,
reflecting the fact that there is no export
demand when the price of wheat is greater
than about $21 per bushel.

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EXAMPLE 4.4 THE DEMAND FOR
HOUSING
There are significant differences in price and
income elasticities of housing demand among
subgroups of the population.

TABLE 4.4: PRICE AND INCOME ELASTICITIES OF THE

DEMAND FOR ROOMS
GROUP PRICE ELASTICITY INCOME ELASTICITY

Single individuals – 0.10 0.21

Married, head of household age

– 0.25 0.06
less than 30, 1 child
Married, head age 30–39, 2 or
– 0.15 0.12
more children
Married, head age 50 or older, 1
– 0.08 0.19
child

In recent years, the demand for housing has been partly driven by speculative demand.
Speculative demand is driven not by the direct benefits one obtains from owning a home
but instead by an expectation that the price will increase.
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EXAMPLE 4.5 THE LONG-RUN
DEMAND FOR GASOLINE
Would higher gasoline prices reduce gasoline
consumption? Figure 4.13 provides a clear
answer: Most definitely.

FIGURE 4.13

GASOLINE PRICES AND PER CAPITA

CONSUMPTION IN 10 COUNTRIES

The graph plots per capita consumption of

gasoline versus the price per gallon
(converted to U.S. dollars) for 10 countries
over the period 2008 to 2010. Each circle
represents the population of the
corresponding country.

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 Question 10 & 11
Suppose that the demand for artichokes (Qa) is given as Qa = 200 - 4P
(a) What is the price elasticity of demand if the price of artichokes is $10?
A) 0
B) -0.25
C) -1
D) -4
E) negative infinity

(b) Suppose that the price of artichokes is increased slightly from $10.
The total expenditure by consumers on artichokes will ________ and the
number of artichokes sold will ________.
A) rise, rise
B) rise, fall
C) fall, rise
D) fall, fall 33
 4.4 CONSUMER SURPLUS

● consumer surplus Difference between what a consumer is

willing to pay for a good and the amount actually paid.

Consumer Surplus

Consumer surplus is the

total benefit from the
consumption of a product,
less the total cost of
purchasing it.

Here, the consumer surplus

associated with six concert
tickets (purchased at $14
per ticket) is given by the
yellow-shaded area.
$6 + $5 + $4 + $3 + $2 + $1
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= $21
Consumer Surplus and Demand

For the market as a whole,

consumer surplus is measured by
the area under the demand curve
and above the line representing
the purchase price of the good.

CS= 1/2 × ($20 − $14) × 6500 =

$19,500.

Applying Consumer Surplus

When added over many individuals, it measures the aggregate benefit

that consumers obtain from buying goods in a market.

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 Question 12 & 13
The area below the demand curve and above the price line measures
A) consumer surplus.
B) economic profit.
C) elasticity of demand.
D) the total value obtained from consuming the good or service.

The demand curve for tickets to the George Winston concert (with
special guest star, Kenny G) is given as follows: Q = 200 - 0.1P
At a price of $30, what is the consumer surplus from concert tickets?
A) $0
B) $20
C) $2,000
D) $1,970
E) $194,045
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EXAMPLE 4.6 THE VALUE OF CLEAN
AIR
Although there is no actual market for clean air,
people do pay more for houses where the air is
clean than for comparable houses in areas with
dirtier air.

FIGURE 4.16

VALUING CLEANER AIR

The yellow-shaded triangle gives the consumer

surplus generated when air pollution is reduced
by 5 parts per 100 million of nitrogen oxide at a
cost of $1000 per part reduced.

The surplus is created because most consumers

are willing to pay more than $1000 for each unit
reduction of nitrogen oxide.

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4.5 NETWORK EXTERNALITIES

● network externality Situation in which each

individual’s demand depends on the purchases of other
individuals.

The Bandwagon Effect

● Positive network externality in which a consumer
wishes to possess a good in part because others do.

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The Bandwagon Effect

Here, as the price of the

product falls from $30 to
$20, the bandwagon
effect causes the
demand for the good to
shift to the right, from D40
to D80.

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40
EXAMPLE 4.7 FACEBOOK
By early 2011, with over 600 million users, Facebook became the world’s second most
visited website (after Google). A strong positive network externality was central to
Facebook’s success.
TABLE 4.5: FACEBOOK USERS
FACEBOOK USERS HOURS PER USER
YEAR
(MILLIONS) PER MONTH
2004 1 Blank Cell
2005 5.5 Blank Cell
2006 12 <1
2007 50 2
2008 100 3
2009 350 5.5
2010 500 7
2011 766 7.5
2012 980 8.5
2013 1171 9
2014 1334 10 Network externalities have been crucial
2015 1517 10.5 drivers for many modern technologies
2016 1654 11 over many years.
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 The Snob Effect
● Negative network externality
in which a consumer wishes
to own an exclusive or unique
good.

Here, as the price falls

from $30,000 to $15,000
and more people buy the
good, the snob effect
causes the demand for
the good to shift to the
left, from D2 to D6.

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 Question 14 & 15
Some luxury product manufacturers will purposefully raise prices
on their goods in order to reduce sales volume. This strategy may
successfully increase sales revenue if the luxury goods are subject
to the ________ effect and have relatively ________ demand.
A) bandwagon, elastic
B) bandwagon, inelastic
C) snob, elastic
D) snob, inelastic

Due to the bandwagon effect, demand for some products is

________ elastic than it would be without the positive network
externality.
A) more
B) less
C) equally
D) more strongly unitary
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 Question 16

The wheat market is perfectly competitive, and the market supply

and demand curves are given by the following equations:
𝑸𝑫 = 𝟐𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎 − 𝟒, 𝟎𝟎𝟎, 𝟎𝟎𝟎𝑷
𝑸𝑺 = 𝟕, 𝟎𝟎𝟎, 𝟎𝟎𝟎 + 𝟐, 𝟓𝟎𝟎, 𝟎𝟎𝟎𝑷
where 𝑸𝑫 and 𝑸𝑺 are quantity demanded and quantity supplied
measured in bushels, and P = price per bushel.

a. Determine consumer surplus at the equilibrium price and

quantity.

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b. Assume that the government has imposed a price floor at $2.25
per bushel and agrees to buy any resulting excess supply. How
many bushels of wheat will the government be forced to buy?
Determine consumer surplus with the price floor.

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 Question 17

Ginger’s utility function is 𝑼 𝒙, 𝒚 = 𝒙𝟐 𝒚. She has income I=$240

and faces prices 𝑷𝒙 = $𝟖, 𝑷𝒚 = $𝟐

a. Determine Ginger’s optimal basket given these prices and her

income.
b. If the price of y increases to $8 and Ginger’s income is
unchanged, what must the price of x fall to in order for her to be
exactly as well off as before the change in 𝑷𝒚 ?

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