lecture demand uses

Uses of Demand Theory: 

Uses of Demand Theory September 27, 1999

Announcements: 

Announcements Group project assignments will be made this week. Watch for an e-mail message with your group and topic. NE XT WEEK (keep checking Web pages for details): exam on Thursday evening review sessions library tutorials during sections

Themes of Today’s Lecture: 

Themes of Today’s Lecture From the Consumer’s Choice Problem to Individual Demand From Individual to Market Demand The Demand Curve and “Willingness to Pay” Consumer Surplus Review of Consumer Demand Theory with More Examples

Li’s Best Choice Reconsidered: 

Li’s Best Choice Reconsidered Consider the choice at PW=$2/lb. The point B is optimal. The point A is feasible but inferior to all points on the red budget line between E and F. The point C is preferred to B but cannot be purchased with Li’s $40 income at the given prices; it is above the red budget line. The point E is feasible but Li prefers more wheat and less rice (B). The point F is feasible but Li prefers less wheat and more rice (B, again). There is no combination that Li prefers to B that she is able to buy.

Handling a change in PW: 

Handling a change in PW Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of $4, $2, and $1 for wheat. The equation MRS=ERS is satisfied at each of the points.

Li’s Demand for Wheat: 

Li’s Demand for Wheat The table shows the amount of wheat that Li demands at each price. These are the points of tangency from the previous slide.

Graph of Li’s Demand for Wheat: 

Graph of Li’s Demand for Wheat When we connect the points from the table in the previous slide we get Li’s demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves.

From IC Map to Li’s Demand for Wheat: 

From IC Map to Li’s Demand for Wheat

Income and Substitution Effects: 

Income and Substitution Effects Economists decompose the effect of a change in price on the quantity demanded into an income and a substitution effect. Income effect: due to the increase in real income associated with a fall in prices (you can buy more with the same nominal income) or the loss of real income associated with a rise in prices (you cannot buy as much as you once did with the same nominal income). Substitution effect: due to the change in the relative price of the good, cheaper goods are substituted for more expensive ones.

Income and Substitution Effects: Price Decline, “X” normal: 

Income and Substitution Effects: Price Decline, “X” normal When the price of a good falls, the quantity demanded rises for two reasons. The income effect: real income is higher because the same money income buys more at the lower prices. For normal goods, then, the income effect of a price fall is positive. The substitution effect: consumers substitute the now cheaper good for ones whose price has not fallen, real income held constant. This increase in demand is called the substitution effect of a price decline.

Li’s Income and Substitution Effects: Price Fall, Rice normal: 

Li’s Income and Substitution Effects: Price Fall, Rice normal Graph shows the income and substitution effects of the fall in the price of wheat from $4/lb. (A) to $1/lb. (C). The movement from point A to point D is the substitution effect: Li buys less rice and more wheat, and would do so even if she had an income of only $20 (as the black budget line shows). The movement from point D to point C is the income effect, the price decline is like giving Li an additional $20 of real income.

Li’s Substitution Effect: 

Li’s Substitution Effect The substitution effect is the amount by which Li's wheat consumption increased holding real income constant. Substitution effect is the difference between Li's consumption of wheat at the new and old prices holding her real income constant, that is, staying on the same indifference curve (compare points A and D).

Li’s Income Effect: 

Li’s Income Effect When the price falls from $4/lb. of wheat to $1/lb. per wheat, Li is able to buy both more wheat and more rice. The income effect is the difference between what she would have bought on the old indifference curve at the lower wheat price (point D) and what she actually did buy with her nominal income ($40) at the lower price (point C). Li increases her consumption of wheat and rice because of the increase in her real income from the price decline.

General effect of a price fall: 

General effect of a price fall Income effect - you feel richer “X” normal Substitution Effect X now looks relatively cheaper PX falls Quantity demanded increases Quantity demanded increases Quantity demanded decreases Total effect is the substitution effect AND the income effect working at the same time. “X” inferior

From Individual to Market Demand: 

From Individual to Market Demand Market demand is the sum of all individual demands in the economy. In the following example there are two consumers of wheat: Li and Juanita. The market demand, then, is the sum of the quantities demand by Li and Juanita.

Juanita’s Demand for Wheat: 

Juanita’s Demand for Wheat Juanita’s income is also $40. Juanita faces the same price for rice as Li: $2/lb. Her preferences are different from Li’s. Her demand for wheat is derived in the figure at the left.

Graph of Juanita’s Demand for Wheat: 

Graph of Juanita’s Demand for Wheat The points A, B and C correspond to Juanita’s best choices given her income and the three prices of wheat illustrated. This is her demand curve for wheat.

Market Demand: 

Market Demand The market demand (green) is the sum of Li’s (blue) and Juanita’s (red) demand for wheat at each price. At PW=4, Li demands 6 lbs., Juanita demands 5 lbs. and the market demand is 11 lbs. At PW=2, Li and Juanita demand 10 lbs. and the market demand is 20 lbs. At PW=1, Li demands 16 lbs., Juanita demands 18 lbs. and the market demand is 34 lbs.

An Alternative View of the Demand Curve: 

An Alternative View of the Demand Curve An alternative interpretation of the demand curve is the consumer’s marginal willingness to pay for the quantity specified. So, another way of looking at the demand curve is as the maximum amount that the consumer is willing to pay (per unit) for the quantity shown.

Willingness to Pay: 

Willingness to Pay Think of the total amount you would pay for X units (say, $27) and for X-1 units (say, $25), then your marginal willingness to pay for the Xth unit is $2 (= 27 -25). Alternatively, we could say that your quantity demanded at the price $2/unit is X because you are willing to pay up to $2/unit for the Xth unit.

Li’s Willingness to Pay for Wheat and Consumer Surplus: 

Li’s Willingness to Pay for Wheat and Consumer Surplus The table at the right shows Li’s willingness to pay for the indicated quantities of wheat. Points we derived on the original demand curve are shown in blue highlight. Her marginal marginal willingness to pay (marginal benefit) is the difference between her willingness to pay for X and X-1 units of wheat. Marginal consumer surplus on each unit is the difference between marginal willingness to pay and the price, PW=$2/lb. Total consumer surplus is the sum of all entries in the marginal consumer surplus column.

Consumer Surplus and Quantity Demanded: 

Consumer Surplus and Quantity Demanded If the price of wheat is $2/lb., then Li buys 10 lbs. of wheat, the point where her marginal benefit of wheat equals its price. Notice that the marginal willingness to pay column (marginal benefit) is just Li’s demand for wheat. (Original points are shown in blue highlight.) When PW=$2 and W=10, Li’s consumer surplus is $72.50, indicating that she would have been willing to pay an additional $72.50 for the wheat she consumed (above the $20 she had to pay). Try it for PW = $4.00

Graphical Measure of Li’s Consumer Surplus: 

Graphical Measure of Li’s Consumer Surplus The area under the demand curve and above the market price is the total consumer surplus. The arrow on the right shows Li’s total consumer surplus when the market price of wheat is $2/lb.

Market Consumer Surplus Question: 

Market Consumer Surplus Question The table at the right is a sample market demand curve. Question: At a market price of $2.00, what is the total consumer surplus?

Market Consumer Surplus Answer: 

Market Consumer Surplus Answer At a market price of $2.00, total expenditures are $14 = 7 x $2.00 Total willingness to pay is $40 = 12 + 8 + 6 + 5 + 4 + 3 + 2. Total consumer surplus = $40 - $14 = $26. Total consumer surplus = sum of marginal consumer surplus = 26 = 10 + 6 + 4 + 3 + 2 + 1 + 0.

Graph of Market Consumer Surplus: 

Graph of Market Consumer Surplus As in the case of individual consumer surplus, the area below the demand curve and above the market price measures the total market consumer surplus.

Why Measure Consumer Surplus?: 

Why Measure Consumer Surplus? An individual’s total consumer surplus on a purchase measures the gain to the consumer from the market transaction. In the market as a whole, the total consumer surplus measures the gain to society from the existence of the market equilibrium price.

Effect of a Tax and Transfer Program: Initial Point: 

Effect of a Tax and Transfer Program: Initial Point Suppose I have the preferences illustrated at the right. Question A: Income: 16 Price of food: 1 Price of shelter: 1 Food = Shelter = Indifference curve =

Answer A: 

Answer A Point A: Income: 16 Price of food: 1 Price of shelter: 1 Food = 7 Shelter = 9 Indifference curve = I4

Effect of a Tax and Transfer Program: Addition of Tax: 

Effect of a Tax and Transfer Program: Addition of Tax Question B: Income: 16 Price of food: 1 Price of shelter: 1 Tax on shelter: 100% Tax-inclusive price of shelter = Food = Shelter = Indifference curve =

Answer B: 

Answer B Point B Income: 16 Price of food: 1 Price of shelter: 1 Tax on shelter: 100% Tax-inclusive price of shelter = 2 Food = 9 Shelter = 3.5 Indifference curve = I2

Effect of a Tax and Transfer Program: Tax & Transfer: 

Effect of a Tax and Transfer Program: Tax & Transfer Question C: Income: 16 Price of food: 1 Price of shelter: 1 Tax on shelter: 100% Transfer payment: 8 Food = Shelter = Indifference curve =

Answer C: 

Answer C Point C Income: 16 Price of food: 1 Price of shelter: 1 Tax on shelter: 100% Transfer payment: 8 Food = 10 Shelter = 7 Indifference curve = I4

Tax and Transfer Systems Give Pure Substitution Effects: 

Tax and Transfer Systems Give Pure Substitution Effects Notice in the example that the consumer ends up on the same indifference curve after the tax and transfer program as in the initial choice (I4). In public finance (the study of tax and transfer systems) this result usually occurs when the tax and transfer system is combined with a balanced budget. In our example, tax receipts are $7 per person (= 7 units of shelter x $1 tax), while the transfer is $8 per person. This is as close to “balanced” as we can get and still be able to graph the consumer’s choice legibly. Knowledge of the substitution effect of the price change induced by the shelter tax is sufficient to predict the effect of the complete tax and transfer system.

Review of Today’s Lecture: 

Review of Today’s Lecture Market demand is the sum of all individual quantities demanded at each price. The demand curve measures marginal willingness to pay for the good. Consumer surplus measures the difference between the amount a consumer was willing to pay and the amount actually paid. Example of a pure substitution effect: the effect of a simultaneous tax and transfer system with a balanced budget.