Copyright (c)2014 John Wiley & Sons, Inc Chapter The Theory of Demand Chapter Five Overview 1 Individual IndividualDemand DemandCurves Curves 2 Income Incomeand andSubstitution SubstitutionEffects Effects&&the theSlope SlopeofofDemand Demand Applications: Applications:   The TheWork-Leisure Work-LeisureTrade-of Trade-of   Consumer ConsumerSurplus Surplus Copyright (c)2014 John Wiley & Sons, Inc •• 3 Constructing ConstructingMarket MarketDemand Demand Chapter Five Chapter Five Overview The TheEffects Effectsof ofaaChange ChangeininPrice Price Copyright (c)2014 John Wiley & Sons, Inc •• Optimal OptimalChoice Choice •• Demand DemandCurve Curve Chapter Five Individual Demand Curves The ThePrice PriceConsumption ConsumptionCurve CurveofofGood GoodX:X: Is the set of optimal baskets for every possible price of Copyright (c)2014 John Wiley & Sons, Inc good x, holding all other prices and income constant Chapter Five Price Consumption Curves Y (units) The price consumption curve for good x can be written as the quantity PPY ==$4 Y $4 I I==$40 $40 consumed of good x for any price of x This is the individual’s demand curve for good x 10 • • • PX = PX = PX = XA=2 XB=10 XC=16 Chapter Five X (units) 20 Copyright (c)2014 John Wiley & Sons, Inc Price Consumption Curve Individual Demand Curve PX Individual IndividualDemand DemandCurve Curve PX = • • PX = • PX = XA XB U increasing X XC Chapter Five Copyright (c)2014 John Wiley & Sons, Inc For ForXX Individual Demand Curve Key Points  The consumer is maximizing utility at every point along the demand curve  The marginal rate of substitution falls along the demand curve as the price of x falls (if there was an interior solution)  As the price of x falls, it causes the consumer to move down and to the right along the demand curve as The demand curve is also the “willingness to pay” curve – and willingness to pay for an additional unit of X falls as more X is consumed Chapter Five Copyright (c)2014 John Wiley & Sons, Inc utility increases in that direction Demand Curve for “X” Algebraically, Algebraically, we we can can solve solve for for the the individual’s individual’s demand demand using using the the following following equations: equations: 1.1.ppxxx++ppyyy==I I x y (If(Ifthis thisnever neverholds, holds,aacorner cornerpoint pointmay maybe besubstituted substitutedwhere wherexx==00ororyy==0)0) Chapter Five Copyright (c)2014 John Wiley & Sons, Inc 2.2.MU = MU /p – at a tangency MUx/p x/pxx = MUyy/pyy – at a tangency Demand Curve with an Interior Solution Suppose that U(x,y) = xy MUx = y and MUy = x The prices of x and y are px and py, respectively and income = I We Have: We Have: x/py = y/px x/py = y/px Substituting the second condition into the budget constraint, we then have: Substituting the second condition into the budget constraint, we then have: pxx + py(px/py)x = I or…x = I/2px pxx + py(px/py)x = I or…x = I/2px Chapter Five 10 Copyright (c)2014 John Wiley & Sons, Inc pxx + pyy = I pxx + pyy = I Change in Income & Demand Income Consumption Curve The The income income consumption consumption curve curve ofof good good xx isis the the set set ofof optimal optimalbaskets basketsfor forevery everypossible possiblelevel levelofofincome income We Wecan cangraph graphthe thepoints pointson onthe theincome incomeconsumption consumptioncurve curve Chapter Five Copyright (c)2014 John Wiley & Sons, Inc as aspoints pointson onaashifting shiftingdemand demandcurve curve 11 Consumer Surplus • The individual’s demand curve can be seen as the individual’s willingness to pay curve • On the other hand, the individual must only actually pay the market price for (all) the units consumed Copyright (c)2014 John Wiley & Sons, Inc • Consumer Surplus is the difference between what the consumer is willing to pay and what the consumer actually pays Chapter Five 30 Consumer Surplus Definition: The net economic benefit to the consumer due to a purchase (i.e the willingness to pay of the consumer net of the actual expenditure on the good) is called consumer surplus The area under an ordinary demand curve and above the market price provides a Copyright (c)2014 John Wiley & Sons, Inc measure of consumer surplus Chapter Five 31 Consumer Surplus G = 5(10-3)(28) = 98 G = 5(10-3)(28) = 98 H+I= 28 +2 = 30 H+I= 28 +2 = 30 Copyright (c)2014 John Wiley & Sons, Inc CS2 = 5(10-2)(32) = 128 CS2 = 5(10-2)(32) = 128 CSP = (10-P)(40-4P) CSP = (10-P)(40-4P) Chapter Five 32 Market Demand The The market market demand demand function function isis the the horizontal horizontal sum sum of of the the individual individual (or (or segment) segment)demands demands InIn other other words, words, market market demand demand isis obtained obtained by by adding adding the the quantities quantities demanded demandedby bythe theindividuals individuals(or (orsegments) segments)atateach eachprice priceand andplotting plottingthis thistotal total Copyright (c)2014 John Wiley & Sons, Inc quantity quantityfor forall allpossible possibleprices prices Chapter Five 33 Market Demand P P P 10 Q = 10 - P Q = 20 – 5P Segment Q Segment Chapter Five Q Market demand 34 Q Copyright (c)2014 John Wiley & Sons, Inc Network Externalities If one consumer's demand for a good changes with the number of other consumers who buy the good, there are network externalities Copyright (c)2014 John Wiley & Sons, Inc • 35 Network Externalities Bandwagon effect: A positive network externality that refers to the increase in each consumer’s demand for a good as more consumers buy the good Copyright (c)2014 John Wiley & Sons, Inc • 36 Network Externalities D60 PX Bandwagon Effect: D30 • (increased quantity demanded when more consumers purchase) • A • 10 B • C Pure Market Demand Price Effect Bandwagon Effect 60 37 Copyright (c)2014 John Wiley & Sons, Inc 20 Network Externalities Snob effect: A negative network externality that refers to the decrease in each consumer’s demand as more consumers buy the good Copyright (c)2014 John Wiley & Sons, Inc • 38 Network Externalities PX Snob Effect: Market Demand • (decreased quantity demanded when more consumers purchase) 900 • C B • D1000 Copyright (c)2014 John Wiley & Sons, Inc • A D1300 Snob Effect X (units) Pure Price Effect 39 Labor-Leisure Trade-off Divide the day into two parts: Work hours and leisure (non work) hours Earns income during work hours and uses the income to pay for activities he enjoys in his leisure time Copyright (c)2014 John Wiley & Sons, Inc • • 40 Defining Labor Supply • • Total Daily income: w(24-L) where w is the hourly wage rate L is the leisure hours Copyright (c)2014 John Wiley & Sons, Inc 24 is the 24 hours in a day 41 Supply of Labor • An increase in wage rate reduces the amount of labor required to buy a unit of the composite good This leads to both a Substitution effect and Income effect Copyright (c)2014 John Wiley & Sons, Inc • 42 Labor Supply Curve The labor supply curve slopes upward over the region where the substitution effect associated with the wage increase outweighs the income effect, but bends backward over the region where the income effect outweighs the substitution effect Copyright (c)2014 John Wiley & Sons, Inc • 43 Copyright (c)2014 John Wiley & Sons, Inc Labor Supply Curve 44 ... Copyright (c)2014 John Wiley & Sons, Inc •• 3 Constructing ConstructingMarket MarketDemand Demand Chapter Five Chapter Five Overview The TheEffects Effectsof ofaaChange ChangeininPrice Price Copyright... Chapter Five Copyright (c)2014 John Wiley & Sons, Inc as aspoints pointson onaashifting shiftingdemand demandcurve curve 11 Copyright (c)2014 John Wiley & Sons, Inc Income Consumption Curve Chapter. .. John Wiley & Sons, Inc Curve is positive Chapter Five 13 Engel Curves I ($) Engel Curve “X “Xisisaanormal normalgood” good” 92 40 10 18 X (units) 24 Chapter Five 14 Copyright (c)2014 John Wiley