MicroEconomics theory and application 12th by browning an zupan chapter 04

Prepared by Dr. Della Lee Sue, Marist College

MICROECONOMICS: Theory & Applications
Chapter 4: Individual and Market Demand
By Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
12th Edition, Copyright 2015

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.


Learning Objectives



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Understand how price changes affect consumption choices.
Differentiate between the income and substitution effects
associated with a price change on the consumption of a
particular good.
Explain the relation between income and substitution effects
in the case of inferior goods.
Explain how individual demand curves are aggregated to
obtain the market demand curve.
(continued)

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Learning Objectives






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(continued)

Demonstrate how consumer surplus represents the net
benefit, or gain, to an individual from consuming one
market basket instead of another.
Investigate the relationship between own-price elasticity of
demand and the price–consumption curve.
Examine network effects: the extent to which an individual
consumer’s demand for a good is influenced by other
individuals’ purchases.
Overview the basics of demand estimation.
Derive the Consumer’s Demand Curve Mathematically.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Understand how price changes affect consumption choices.

4.1 PRICE CHANGES AND
CONSUMPTION CHOICES

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Price Changes and Consumption
Choices


Price-consumption curve: a curve that identifies the
optimal market basket associated with each possible price of
a good, holding constant all other determinants of demand.



The consumer’s demand curve can be derived from the
price-consumption curve.

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Figure 4.1 – Derivation of the
Consumer’s Demand Curve

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Some Remarks about the
Demand Curve

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

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The consumer’s level of well-being varies along the demand curve.
The prices of other goods are held constant among a demand curve, but
the quantities purchased of these other goods can vary.
At each point on the demand curve, the consumer’s optimality
condition is satisfied:
MRSXO = PX/PO
where “O” refers to “other goods” (composite good).
The demand curve identifies the marginal benefit associated with
various levels of consumption.

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Figure 4.2 - Do Demand Curves Always
Slope Downward?

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Differentiate between the income and substitution effects associated with
a price change on the consumption of a particular good.

4.2 INCOME AND SUBSTITUTION
EFFECTS OF A PRICE CHANGE

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Income and Substitution Effects of a
Price Change


Income effect – a change in a consumer’s real purchasing
power brought about by a change in the price of a good



Substitution effect – an incentive to increase consumption
of a good whose price falls, at the expense of other, now
relatively more expensive, goods

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Income and Substitution Effects
Illustrated: The Normal-Good Case
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Substitution Effect: change in consumption due to a
change in relative prices, with no change in real income or
well-being
Income Effect: change in consumption due to a change in
real income or well-being, with no change in relative prices
For a normal good, both effects imply more consumption at
a lower price and less consumption at a higher price.
Demand curve slopes downward.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Remarks about Income and Substitution Effects of a
Price Reduction: The Normal-Good Case
(See Figure 4.3)

 The substitution effect is shown by the difference between the markets
at points W and J.


The income effect is shown by the change in consumption when the
consumer moves from point J on U1 to point W’ on U2.



Note that the substitution effect of any price change always implies
more consumption of a good at a lower price and less consumption at a
higher price.



The demand curve for a normal good must therefore be downward
sloping.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 4.3 - Income and Substitution Effects
of a Price Reduction: The Normal-Good Case

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The Income and Substitution Effects Associated
with a Gasoline Tax-Plus-Rebate Program

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Excise Tax – a tax on a specific good
Objective: encourage consumers to reduce their use of
gasoline
What can be done with the tax revenue?
 Tax rebate to consumers
 Reduce the government’s outstanding debt
Would an excise tax and a tax rebate curtail consumption?

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Figure 4.4 - Tax-Plus-Rebate Program

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Explain the relation between income and substitution effects in the case

of inferior goods.

4.3 INCOME AND SUBSTITUTION
EFFECTS: INFERIOR GOODS

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Income and Substitution Effects
Illustrated: Inferior Goods
Two possibilities:
 Substitution effect > income effect
 Demand curve slopes downward


Income effect > substitution effect
 Demand curve slopes upward
 Giffen Good

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Figure 4.5 - Income and Substitution
Effects for an Inferior Goods

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Explain how individual demand curves are aggregated to obtain the
market demand curve.

4.4 FROM INDIVIDUAL TO MARKET
DEMAND

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From Individual to Market Demand


Horizontal summation: add quantities of individual demand
curves at each price to obtain the market demand curve



All individual demand curves slope downward => market
demand curve slopes downward



If some individual demand curves slope upward => market
demand curve can till slope downward

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 4.6 – Summing Individual
Demands to Obtain Market Demand

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Demonstrate how consumer surplus represents the net benefit, or gain, to
an individual from consuming one market basket instead of another.

4.5 CONSUMER SURPLUS

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Consumer Surplus


Consumer surplus – a measure of the net gain to consumers from
purchasing a good arising from its cost being below the maximum that
consumers are willing to pay



Total benefit – the total value a consumer derives from a particular
amount of a good and thus the maximum amount the consumer would
be willing to pay for that amount of the good.



Marginal benefit – the incremental value a consumer derives from
consuming an additional unit of a good and thus the maximum amount
the consumer would pay for that additional unit

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Calculating Consumer Surplus
[NOTE: See Figure 4.7]

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Figure 4. 7 – Consumer Surplus

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