1. Chapter 4
Individual and Market Demand

2. CONSUMER CHOICE
©2005 Pearson Education, Inc.

3. Consumer Choice
Given preferences and budget
constraints, how do consumers choose
what to buy?
Consumers choose a combination of
goods that will maximize their
satisfaction, given the limited budget
available to them
©2005 Pearson Education, Inc. Chapter 3 3

4. The Budget Line
Clothing
A
(I/PC) = 40 ∆C 1 PF
Slope = = - =-
B ∆F 2 PC
30
10 D
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF)
©2005 Pearson Education, Inc. Chapter 3 4

5. Indifference Map
Clothing
Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3
U2
U1
Food
©2005 Pearson Education, Inc. 5

6. HOW DO CONSUMERS
CONSUME?
©2005 Pearson Education, Inc. 6

7. Consumer Choice
Clothing
(units per
week)
40
A
30 D
20 C
U3
U1 U2
B
0 20 40 80 Food (units per week)
©2005 Pearson Education, Inc. Chapter 3 7

8. Consumer Choice
Graphically, we can see different
indifference curves of a consumer
choosing between clothing and food
Remember that U3 > U2 > U1 for our
indifference curves
Consumer wants to choose highest utility
within their budget
©2005 Pearson Education, Inc. Chapter 3 8

9. Consumer Choice
Clothing
(units per
week)
•A, B, C on budget line
40 •D highest utility but not
affordable
A
30 D
20 C
U3
U1 U2
B
0 20 40 80 Food (units per week)
©2005 Pearson Education, Inc. Chapter 3 9

10. Consumer Choice
 The maximizing market basket must
satisfy two conditions:
1. It must be located on the budget line
 They spend all their income – more is better
1. It must give the consumer the most
preferred combination of goods and
services
©2005 Pearson Education, Inc. Chapter 3 10

11. Consumer Choice
Clothing
(units per
week)
•A, B, C on budget line
40 •D highest utility but not
affordable
A •C highest affordable
utility
30 D •Consumer chooses C
20 C
U3
U1 U2
B
0 20 40 80 Food (units per week)
©2005 Pearson Education, Inc. Chapter 3 11

12. Consumer Choice
Consumer will choose highest
indifference curve on budget line
In previous graph, point C is where the
indifference curve is just tangent to the
budget line
Slope of the budget line equals the slope
of the indifference curve at this point
©2005 Pearson Education, Inc. Chapter 3 12

13. Consumer Choice
Recall, the slope of an indifference curve
is:
∆C
MRS = −
∆F
Further, the slope of the budget line is:
PF
Slope = −
PC
©2005 Pearson Education, Inc. Chapter 3 13

14. Consumer Choice
Therefore, it can be said at consumer’s
optimal consumption point,
PF
MRS =
PC
©2005 Pearson Education, Inc. Chapter 3 14

15. Marginal Utility and Consumer
Choice
When consumers maximize satisfaction:
MRS = PF /PC
Since the MRS is also equal to the ratio of the
marginal utility of consuming F and C
MU F /MU C = PF /PC
©2005 Pearson Education, Inc. Chapter 3 15

16. Marginal Utility and Consumer
Choice
Rearranging, gives the equation for utility
maximization:
MU F / PF = MU C / PC
©2005 Pearson Education, Inc. Chapter 3 16

17. Consumer Choice
It can be said that satisfaction is
maximized when marginal rate of
substitution (of F and C) is equal to the
ratio of the prices (of F and C)
Note this is ONLY true at the optimal
consumption point
©2005 Pearson Education, Inc. Chapter 3 17

18. Marginal Utility and Consumer
Choice
Total utility is maximized when the
budget is allocated so that the marginal
utility per dollar of expenditure is the
same for each good.
This is referred to as the equal marginal
principle.
©2005 Pearson Education, Inc. Chapter 3 18

19. Consumer Choice
If MRS ≠ PF/PC then individuals can
reallocate basket to increase utility
If MRS > PF/PC
Will increase food and decrease clothing until
MRS = PF/PC
If MRS < PF/PC
Will increase clothing and decrease food until
MRS = PF/PC
©2005 Pearson Education, Inc. Chapter 3 19

20. Consumer Choice
Clothing
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS = -10/10 = 1
is greater than the
B
30 price ratio = 1/2
-10C
20
+10F U1
0 20 40 80 Food (units per week)
©2005 Pearson Education, Inc. Chapter 3 20

21. Consumer Choice:
An Application Revisited
Consider two groups of consumers, each
wishing to spend $10,000 on the styling
and performance of a car
Each group has different preferences
©2005 Pearson Education, Inc. Chapter 3 21

22. Consumer Choice:
An Application Revisited
By finding the point of tangency between
a group’s indifference curve and the
budget constraint, auto companies can
see how much consumers value each
attribute
©2005 Pearson Education, Inc. Chapter 3 22

23. Consumer Choice:
An Application Revisited
Styling
$10,000 These consumers
want performance
worth $7000 and styling
worth $3000
$3,000
$7,000 $10,000 Performance
©2005 Pearson Education, Inc. Chapter 3 23

24. Consumer Choice:
An Application Revisited
Styling
These consumers
$10,000 want styling worth
$7000 and
performance worth
$7,000 $3000
$3,000 $10,000 Performance
©2005 Pearson Education, Inc. Chapter 3 24

25. Consumer Choice:
An Application Revisited
Once a company knows preferences, it
can design a production and marketing
plan
Company can then make a sensible
strategic business decision on how to
allocate performance and styling on new
cars
©2005 Pearson Education, Inc. Chapter 3 25

26. CORNER SOLUTION
©2005 Pearson Education, Inc. Chapter 4 26

27. Consumer Choice
A corner solution exists if a consumer
buys in extremes, and buys all of one
category of good and none of another
MRS is not necessarily equal to PA/PB
©2005 Pearson Education, Inc. Chapter 3 27

28. A Corner Solution
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3
B Ice Cream (cup/month)
©2005 Pearson Education, Inc. Chapter 3 28

29. A Corner Solution
 At point B, the MRS of ice cream for frozen
yogurt is greater than the slope of the budget
line
 If the consumer could give up more frozen
yogurt for ice cream, he would do so
 However, there is no more frozen yogurt to give
up
 Opposite is true if corner solution was at point A
©2005 Pearson Education, Inc. Chapter 3

30. A Corner Solution
When a corner solution arises, the
consumer’s MRS does not necessarily
equal the price ratio
In this instance it can be said that:
PIceCream
MRS ≥
PFrozen Yogurt
©2005 Pearson Education, Inc. Chapter 3 30

31. A Corner Solution
If the MRS is, in fact, significantly greater
than the price ratio, then a small
decrease in the price of frozen yogurt will
not alter the consumer’s market basket
©2005 Pearson Education, Inc. Chapter 3 31

32. A Corner Solution - Example
Suppose Jane Doe’s parents set up a
trust fund for her college education
The money must be used only for
education
Although a welcome gift, an unrestricted
gift might be better
©2005 Pearson Education, Inc. Chapter 3 32

33. A Corner Solution - Example
Original budget line, PQ, with a market
basket, A, of education and other goods
Trust fund shifts out the budget line as
long as trust fund, PB, is spent on
education
Jane increases satisfaction, moving to
higher indifference curve, U2
©2005 Pearson Education, Inc. Chapter 3 33

34. A Corner Solution - Example
Other
Consumption
($) •Jane better off
on U2
•B is corner
solution
P
B •MRS ≠ PE/POG
U2
A
U1
Q Education ($)
©2005 Pearson Education, Inc. Chapter 3 34

35. A Corner Solution - Example
Other
Consumption
($) •If gift is
unrestricted, Jane
C can be at point C
on U3
U3 •Better off than
P
with restricted gift
B U2
A
U1
Q Education ($)
©2005 Pearson Education, Inc. Chapter 3 35

36. 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
©2005 Pearson Education, Inc. Chapter 4 36

37. DERIVING DEMAND FROM
CONSUMER CHOICE
©2005 Pearson Education, Inc. Chapter 4 37

38. Effect of a Price Change
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
©2005 Pearson Education, Inc. Chapter 4 38

39. Effect of a Price Change
Clothing
The Price-
10 Consumption Curve
traces out the utility
maximizing market
basket for each price
6 A
of food
U1 D
5
B
4 U3
U2
Food (units
per month)
4 12 20
©2005 Pearson Education, Inc. Chapter 4 39

40. Effect of a Price Change
 By changing prices
and showing what Demand Schedule
the consumer will
purchase, we can P Q
create a demand
schedule and $2.00 4
demand curve for the
$1.00 12
individual
 From the previous $0.50 20
example:
©2005 Pearson Education, Inc. Chapter 4 40

41. Effect of a Price Change
Price
of Food
E Individual Demand relates
$2.00 the 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)
©2005 Pearson Education, Inc. Chapter 4 41

42. 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
©2005 Pearson Education, Inc. Chapter 4 42

43. Effect of a Price Change
Price
of Food
E When the price falls,
$2.00 Pf /Pc & MRS also fall
• E: Pf /Pc = 2/2 = 1 = MRS
• G: Pf /Pc = 1/2 = .5 = MRS
G
$1.00 • H:Pf /Pc = .5/2 = .25 = MRS
$.50 H
Demand Curve
Food (units
4 12 20 per month)
©2005 Pearson Education, Inc. Chapter 4 43

44. 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
©2005 Pearson Education, Inc. Chapter 4 44

45. CONSUMER CHOICE AND
INCOME CHANGES
©2005 Pearson Education, Inc. Chapter 4 45

46. 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
©2005 Pearson Education, Inc. Chapter 4 46

47. 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 of
7 D market basket.
U3
5 U2
B
3
A U1
Food (units
4 per month)
10 16
©2005 Pearson Education, Inc. Chapter 4 47

48. Individual Demand
Income Changes
The income-consumption curve traces out
the utility-maximizing combinations of food
and clothing associated with every income
level
©2005 Pearson Education, Inc. Chapter 4 48

49. 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
©2005 Pearson Education, Inc. Chapter 4 49

50. Effects of Income Changes
Clothing
(units per The Income Consumption
month) Curve traces out the utility
maximizing market basket
for each income level
Income Consumption
7 D Curve
U3
5 U2
B
3
A U1
Food (units
4 per month)
10 16
©2005 Pearson Education, Inc. Chapter 4 50

51. Effects of Income Changes
Price
An increase in income, from
of
$10 to $20 to $30, with the
food 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)
©2005 Pearson Education, Inc. Chapter 4 51

52. 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
©2005 Pearson Education, Inc. Chapter 4 52

53. 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
©2005 Pearson Education, Inc. Chapter 4 53

54. An Inferior Good
Steak Both hamburger
(units per Income-Consumption and steak behave
month) Curve as a normal good,
C between A and B...
10
U3
…but hamburger
becomes an inferior
good when the income
B consumption curve
5
bends backward
between B and C.
U2
A
U1
Hamburger
30 (units per month)
5 10 20
©2005 Pearson Education, Inc. Chapter 4 54

55. 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
©2005 Pearson Education, Inc. Chapter 4 55

56. Engel Curves
Income 30
($ per
month)
Engel curves slope
20 upward for
normal goods.
10
Food (units
4 8 12 16 per month)
©2005 Pearson Education, Inc. Chapter 4 56

57. 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)
©2005 Pearson Education, Inc. Chapter 4 57

58. Annual US Household
Consumer Expenditures
©2005 Pearson Education, Inc. Chapter 4 58

59. INCOME AND SUBSTITUTION
EFFECT
©2005 Pearson Education, Inc. Chapter 4 59

60. Income and Substitution Effects
A change in the price of a good has two
effects:
Substitution Effect
Income Effect
©2005 Pearson Education, Inc. Chapter 4 60

61. 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
©2005 Pearson Education, Inc. Chapter 4 61

62. Income and Substitution Effects
Income Effect
Consumers experience an increase in real
purchasing power when the price of one
good falls
©2005 Pearson Education, Inc. Chapter 4 62

63. 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
©2005 Pearson Education, Inc. Chapter 4 63

64. 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
©2005 Pearson Education, Inc. Chapter 4 64

65. Income and Substitution Effects
Income Effect
Even with inferior goods, the income effect is
rarely large enough to outweigh the
substitution effect
©2005 Pearson Education, Inc. Chapter 4 65

66. Income and Substitution
Effects: Normal Good
Clothing
When the price of food falls,
(units per consumption increases by F1F2
month) R as the consumer moves from A
to B.
The substitution effect, F1E,
(from point A to D), changes the
C1 A relative prices but keeps real income
(satisfaction) constant.
The income effect, EF2,
(from D to B) keeps relative
D B prices constant but
C2 increases purchasing power.
Substitution U2
Effect U1
Food (units
O F1 Total Effect E S F2 T per month)
©2005 Pearson Education, Inc. Chapter 4
Income Effect 66

67. Income and Substitution
Effects: Inferior Good
Clothing
(units per Since food is an
month) R inferior good, the
income effect is
negative. However,
the substitution effect
A is larger than the
income effect.
B
U2
D
Substitution
Effect U1
Food (units
O F1 E S F2 T per month)
Total Effect
©2005 Pearson Education, Inc. Chapter 4
Income Effect 67

68. Income and Substitution Effects
A Special Case: The Giffen Good
The income effect may theoretically be large
enough to cause the demand curve for a
good to slope upward
This rarely occurs and is of little practical
interest
©2005 Pearson Education, Inc. Chapter 4 68

69. Market Demand
Market Demand Curves
A curve that relates the quantity of a good
that all consumers in a market buy to the
price of that good
The sum of all the individual demand curves
in the market
©2005 Pearson Education, Inc. Chapter 4 69

70. MARKET DEMAND
©2005 Pearson Education, Inc. Chapter 4 70

71. Determining the Market Demand
Curve
Market
Price A B C
Demand
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
©2005 Pearson Education, Inc. Chapter 4 71

72. Summing to Obtain a
Market Demand Curve
Price
5 The market demand
curve is obtained by
summing the consumer’s
4 demand curves
3
Market Demand
2
1
DA DB DC
0 5 10 15 20 25 30 Quantity
©2005 Pearson Education, Inc. Chapter 4 72

73. Market Demand
From this analysis one can see two
important points:
The market demand will shift to the right as
more consumers enter the market
Factors that influence the demands of many
consumers will also affect the market
demand
©2005 Pearson Education, Inc. Chapter 4 73

74. Market Demand
Aggregation is important to be able to
discuss regarding demand for different
groups
Households with children
Consumers aged 20 – 30, etc.
©2005 Pearson Education, Inc. Chapter 4 74

75. The Aggregate Demand for
Wheat
The demand for US wheat is comprised
of two components:
Domestic demand
Export demand
Total demand for wheat can be obtained
by aggregating these two demands
©2005 Pearson Education, Inc. Chapter 4 75

76. The Aggregate Demand for
Wheat
The domestic demand for wheat is given
by the equation:
QDD = 1465 - 88P
The export demand for wheat is given by
the equation:
QDE = 1344 - 138P
©2005 Pearson Education, Inc. Chapter 4 76

77. The Aggregate Demand for
Wheat
Domestic demand is relatively price
inelastic (Ed = -0.2)
Export demand is more price elastic (Ed =
-0.4)
Poorer countries that import US wheat turn to
other grains and food if wheat prices
increase
©2005 Pearson Education, Inc. Chapter 4 77

78. The Aggregate Demand for
Wheat
Price
Total world demand is
18 the horizontal sum of the
domestic demand AB and
A
export demand CD.
16
Above C, export demand is
zero, so domestic demand =
total demand = AE segment
10 C E
Total Demand
Export
Demand Domestic
Demand
D B F
0 Wheat
©2005 Pearson Education, Inc. Chapter 4 78

79. CONSUMER SURPLUS
©2005 Pearson Education, Inc. Chapter 4 79

80. Consumer Surplus
Consumers buy goods because it makes
them better off
Consumer Surplus measures how much
better off they are
©2005 Pearson Education, Inc. Chapter 4 80

81. Consumer Surplus
Consumer Surplus
The difference between the maximum
amount a consumer is willing to pay for a
good and the amount actually paid
Can calculate consumer surplus from the
demand curve
©2005 Pearson Education, Inc. Chapter 4 81

82. Consumer Surplus - Example
Student wants to buy concert tickets
Demand curve tells us willingness to pay
for each concert ticket
1st ticket worth $20 but price is $14 so student
generates $6 worth of surplus
Can measure this for each ticket
Total surplus is addition of surplus for each
ticket purchased
©2005 Pearson Education, Inc. Chapter 4 82

83. Consumer Surplus - Example
Price The consumer surplus
($ per 20 of purchasing 6 concert
ticket) tickets is the sum of the
19 surplus derived from
18 each one individually.
17
16
Consumer Surplus
15
6 + 5 + 4 + 3 + 2 + 1 =
14 21 Market Price
13 Will not buy more than 7
because surplus is
negative
0 1 2 3 4 5 6 Rock Concert Tickets
©2005 Pearson Education, Inc. Chapter 4 83

84. Consumer Surplus
The stepladder demand curve can be
converted into a straight-line demand
curve by making the units of the good
smaller
Consumer surplus is the area under the
demand curve and above the price
©2005 Pearson Education, Inc. Chapter 4 84

85. Consumer Surplus
Price Consumer Surplus
($ per 20
ticket) for the Market Demand
19
18 CS = ½ ($20 - $14)*(1600)
= $19,500
17
16 Consumer
Surplus
15
14 Market Price
13
Demand Curve
Actual
Expenditure
0 1 2 3 4 5 6
Rock Concert Tickets
©2005 Pearson Education, Inc. Chapter 4 85

86. Applying Consumer Surplus
 Combining consumer surplus with the
aggregate profits that producers obtain,
we can evaluate:
1. Costs and benefits of different market
structures
2. Public policies that alter the behavior of
consumers and firms
©2005 Pearson Education, Inc. Chapter 4 86

87. Applying Consumer Surplus –
An Example
The Value of Clean Air
Air is free in the sense that we don’t pay to
breathe it
The Clean Air Act was amended in 1970
Question: Were the benefits of cleaning up
the air worth the costs?
©2005 Pearson Education, Inc. Chapter 4 87

88. The Value of Clean Air
Empirical data determined estimates for
the demand for clean air
No market exists for clean air, but can
see people are willing to pay for it
Ex: People pay more to buy houses where
the air is clean
©2005 Pearson Education, Inc. Chapter 4 88

89. The Value of Cleaner Air
Using these empirical estimates, we can
measure people’s consumer surplus for
pollution reduction from the demand
curve
©2005 Pearson Education, Inc. Chapter 4 89

90. Valuing Cleaner Air
Value
The shaded area represents the
2000 consumer surplus generated
when air pollution is
reduced by 5 parts per 100
million of nitrous oxide at
a cost of $1000 per
part reduced.
A
1000
NOX (pphm)
0 5 10 Pollution Reduction
©2005 Pearson Education, Inc. Chapter 4 90

91. Value of Cleaner Air
A full cost-benefit analysis would include
total benefit of cleanup
Total benefits would be compared to total
costs to determine if the clean up was
worthwhile
©2005 Pearson Education, Inc. Chapter 4 91