Chapter 4

Report
Chapter 4
Individual and Market Demand
Topics to be Discussed
 Individual Demand
 Income and Substitution Effects
 Market Demand
 Consumer Surplus
 Network Externalities
 Empirical Estimation of Demand
©2005 Pearson Education, Inc.
Chapter 4
2
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.
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3
Effect of a Price Change
Clothing
Assume:
• I = $20
• PC = $2
• PF = $2, $1, $0.50
10
A
6
U1
5
Each price leads to
different amounts of
food purchased
D
B
4
U3
U2
4
©2005 Pearson Education, Inc.
12
20
Chapter 4
Food (units
per month)
4
Effect of a Price Change
Clothing
The PriceConsumption Curve
traces out the utility
maximizing market
basket for each price
of food
10
A
6
U1
5
D
B
4
U3
U2
4
©2005 Pearson Education, Inc.
12
20
Chapter 4
Food (units
per month)
5
Effect of a Price Change
 By changing prices
and showing what
the consumer will
purchase, we can
create a demand
schedule and
demand curve for the
individual
 From the previous
example:
©2005 Pearson Education, Inc.
Chapter 4
Demand Schedule
P
Q
$2.00
4
$1.00
12
$0.50
20
6
Effect of a Price Change
Price
of Food
Individual Demand relates
the quantity of a good that
a consumer will buy to the
price of that good.
E
$2.00
G
$1.00
Demand Curve
$.50
H
4
©2005 Pearson Education, Inc.
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20
Chapter 4
Food (units
per month)
7
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.
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Effect of a Price Change
Price
of Food
When the price falls,
Pf /Pc & MRS also fall
E
$2.00
• E: Pf /Pc = 2/2 = 1 = MRS
• G: Pf /Pc = 1/2 = .5 = MRS
• H:Pf /Pc = .5/2 = .25 = MRS
G
$1.00
$.50
H
4
©2005 Pearson Education, Inc.
12
Demand Curve
20
Chapter 4
Food (units
per month)
9
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.
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Effects of Income Changes
Clothing
(units per
month)
Assume: Pf = $1, Pc = $2
I = $10, $20, $30
7
D
5
U3
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket.
U2
B
3
U1
A
4
©2005 Pearson Education, Inc.
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16
Chapter 4
Food (units
per month)
11
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.
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12
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.
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Effects of Income Changes
Clothing
(units per
month)
The Income Consumption
Curve traces out the utility
maximizing market basket
for each income level
7
D
5
U3
Income Consumption
Curve
U2
B
3
U1
A
4
©2005 Pearson Education, Inc.
10
16
Chapter 4
Food (units
per month)
14
Effects of Income Changes
Price
of
food
An increase in income, from
$10 to $20 to $30, with the
prices fixed, shifts the
consumer’s demand curve
to the right as well.
E
$1.00
G
H
D3
D2
D1
4
©2005 Pearson Education, Inc.
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16
Chapter 4
Food (units
per month)
15
Individual Demand
 Income Changes
When the income-consumption curve has a
positive slope:
 The
quantity demanded increases with income
 The income elasticity of demand is positive
 The good is a normal good
©2005 Pearson Education, Inc.
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Individual Demand
 Income Changes
When the income-consumption curve has a
negative slope:
 The
quantity demanded decreases with income
 The income elasticity of demand is negative
 The good is an inferior good
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An Inferior Good
Steak
(units per
month)
Both hamburger
and steak behave
as a normal good,
between A and B...
Income-Consumption
Curve
C
10
U3
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C.
B
5
U2
A
U1
5
©2005 Pearson Education, Inc.
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Chapter 4
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Hamburger
(units per month)
18
Individual Demand
 Engel Curves
 Engel
curves relate the quantity of good
consumed to income
 If the good is a normal good, the Engel curve
is upward sloping
 If the good is an inferior good, the Engel
curve is downward sloping
©2005 Pearson Education, Inc.
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Engel Curves
Income 30
($ per
month)
Engel curves slope
upward for
normal goods.
20
10
4
©2005 Pearson Education, Inc.
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12
Chapter 4
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Food (units
per month)
20
Engel Curves
Income 30
($ per
month)
Inferior
Engel curves are
backward bending
for inferior goods.
20
Normal
10
4
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12
Chapter 4
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Food (units
per month)
21
Annual US Household
Consumer Expenditures
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Substitutes & Complements
 Two goods are considered substitutes if
an increase (decrease) in the price of
one leads to an increase (decrease) in
the quantity demanded of the other
Ex: movie tickets and video rentals
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Substitutes & Complements
 Two goods are considered complements
if an increase (decrease) in the price of
one leads to a decrease (increase) in the
quantity demanded of the other
Ex: gasoline and motor oil
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Substitutes & Complements
 If two goods are independent, then a
change in the price of one good has no
effect on the quantity demanded of the
other
Ex: price of chicken and price of airplane
tickets
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Substitutes & Complements
 If the price consumption curve is
downward-sloping, the two goods are
considered substitutes
 If the price consumption curve is upwardsloping, the two goods are considered
complements
 They could be both
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Income and Substitution Effects
 A change in the price of a good has two
effects:
Substitution Effect
Income Effect
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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.
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Income and Substitution Effects
 Income Effect
Consumers experience an increase in real
purchasing power when the price of one
good falls
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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.
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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.
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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.
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Income and Substitution
Effects: Normal Good
Clothing
(units per
month) R
When the price of food falls,
consumption increases by F1F2
as the consumer moves from A
to B.
The substitution effect, F1E,
(from point A to D), changes the
A
relative prices but keeps real income
(satisfaction) constant.
C1
D
B
C2
U2
Substitution
Effect
O
F1
©2005 Pearson Education, Inc.
Total Effect
The income effect, EF2,
(from D to B) keeps relative
prices constant but
increases purchasing power.
U1
E S
Chapter 4
F2
T
Income Effect
Food (units
per month)
33
Income and Substitution
Effects: Inferior Good
Clothing
(units per
month) R
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.
A
B
U2
D
Substitution
Effect
O
F1
Total Effect
©2005 Pearson Education, Inc.
U1
E S
F2
Chapter
4
Income
Effect
T
Food (units
per month)
34
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.
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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.
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Determining the Market Demand
Curve
Price
A
B
C
Market
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.
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Summing to Obtain a
Market Demand Curve
Price
5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
Market Demand
2
1
0
DA
5
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DB
10
DC
15
Chapter 4
20
25
30
Quantity
38
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.
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Market Demand
 Aggregation is important to be able to
discuss regarding demand for different
groups
Households with children
Consumers aged 20 – 30, etc.
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Market Demand
 Price Elasticity of Demand
Measures the percentage change in the
quantity demanded resulting from a percent
change in price
EP 
©2005 Pearson Education, Inc.
% Q
% P

 Q/Q
 P/P
Chapter 4

Q P
P Q
41
Price Elasticity of Demand
 Inelastic Demand
Ep is less than 1 in absolute value
Quantity demanded is relatively
unresponsive to a change in price
|%Q| < |%P|
Total expenditure (P*Q) increases when price
increases
©2005 Pearson Education, Inc.
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Price Elasticity of Demand
 Elastic Demand
Ep is greater than than 1 in absolute value
Quantity demanded is relatively responsive
to a change in price
|%Q| > |%P|
Total expenditure (P*Q) decreases when
price increases
©2005 Pearson Education, Inc.
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Price Elasticity and
Consumer Expenditure
©2005 Pearson Education, Inc.
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Price Elasticity of Demand
 Isoelastic Demand
When price elasticity of demand is constant
along the entire demand curve
Demand curve is bowed inward (not linear)
©2005 Pearson Education, Inc.
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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.
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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.
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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.
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The Aggregate Demand for
Wheat
Price
Total world demand is
the horizontal sum of the
domestic demand AB and
export demand CD.
18
A
16
10
Above C, export demand is
zero, so domestic demand =
total demand = AE segment
C
E
Total Demand
Export
Demand
Domestic
Demand
D
B
0
©2005 Pearson Education, Inc.
Chapter 4
F
Wheat
49
Consumer Surplus
 Consumers buy goods because it makes
them better off
 Consumer Surplus measures how much
better off they are
©2005 Pearson Education, Inc.
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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
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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 $6 worth of surplus
Can measure this for each ticket
Total surplus is addition of surplus for each
ticket purchased
©2005 Pearson Education, Inc.
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Consumer Surplus - Example
Price
($ per
ticket)
The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
20
19
18
17
16
15
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 = 21
Market Price
14
13
0
Will not buy more than 7
because surplus is
negative
1
©2005 Pearson Education, Inc.
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3
4
Chapter 4
5
6
Rock Concert Tickets
53
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.
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Consumer Surplus
Price
($ per
ticket)
Consumer Surplus
for the Market Demand
20
19
CS = ½ ($20 - $14)*(1600)
= $19,500
18
17
16
15
Consumer
Surplus
Market Price
14
13
Demand Curve
Actual
Expenditure
0
1
©2005 Pearson Education, Inc.
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3
4
Chapter 4
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6
Rock Concert Tickets
55
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.
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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.
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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.
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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.
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Valuing Cleaner Air
Value
2000
A
1000
0
©2005 Pearson Education, Inc.
5
The shaded area represents the
consumer surplus generated
when air pollution is
reduced by 5 parts per 100
million of nitrous oxide at
a cost of $1000 per
part reduced.
10
Chapter 4
NOX (pphm)
Pollution Reduction
60
Value of Cleaner Air
 A full cost-benefit analysis would include
total benefit of cleanup
 Total benefits would be compared to total
costs to determine if the clean up was
worthwhile
©2005 Pearson Education, Inc.
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Network Externalities
 Up to this point we have assumed that
people’s demands for a good are
independent of one another
 For some goods, one person’s demand
also depends on the demands of other
people
©2005 Pearson Education, Inc.
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Network Externalities
 If this is the case, a network externality
exists
 Network externalities can be positive or
negative
©2005 Pearson Education, Inc.
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Network Externalities
 A positive network externality exists if the
quantity of a good demanded by a
consumer increases in response to an
increase in purchases by other
consumers
 Negative network externalities are just
the opposite
©2005 Pearson Education, Inc.
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Network Externalities
 The Bandwagon Effect
This is the desire to be in style, to have a
good because almost everyone else has it,
or to indulge in a fad
This is the major objective of marketing and
advertising campaigns (e.g. toys, clothing)
Positive network externality in which a
consumer wishes to possess a good in part
because others do
©2005 Pearson Education, Inc.
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Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right.
Quantity
20
©2005 Pearson Education, Inc.
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60
Chapter 4
80
100
(thousands per month)
66
Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
The market demand
curve is found by joining
the points on the individual
demand curves. It is relatively
more elastic.
Demand
Quantity
20
©2005 Pearson Education, Inc.
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60
Chapter 4
80
100
(thousands per month)
67
Positive Network
Externality: Bandwagon Effect
Price
($ per
unit)
D20
D40 D60 D80 D100
$30
But as more
people
Suppose
the price
fallsbuy
good,
it becomes
fromthe
$30
to $20.
If there
to own it and
werestylish
no bandwagon
effect,
the quantity
demanded
quantity
demanded
would
increases
only increase
tofurther.
48,000
Demand
$20
Bandwagon
Effect
Pure Price
Effect
Quantity
20
©2005 Pearson Education, Inc.
40 48 60
Chapter 4
80
100
(thousands per month)
68
Network Externalities
 The Snob Effect
If the network externality is negative, a snob
effect exists
 The snob effect refers to the desire to
own exclusive or unique goods
 The quantity demanded of a “snob” good
is higher the fewer the people who own it
©2005 Pearson Education, Inc.
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Network Externality: Snob Effect
Price
($ per
unit)
Demand
$30,000
Originally demand is D2,
when consumers think 2,000
people have bought a good.
However, if consumers think 4,000
people have bought the good,
demand shifts from D2 to D6 and its
snob value has been reduced.
$15,000
D2
Pure Price Effect
D4
D8
2
©2005 Pearson Education, Inc.
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6
8
Chapter 4
D6
Quantity
14
(thousands
per month)
70
Network Externality: Snob Effect
Price
($ per
unit)
The demand is less elastic and
as a snob good its value is greatly
reduced if more people own
it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.
Demand
$30,000
Net Effect
Snob Effect
$15,000
D2
Pure Price Effect
D4
D8
2
©2005 Pearson Education, Inc.
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6
8
Chapter 4
D6
Quantity
14
(thousands
per month)
71
Empirical Estimation of Demand
 The most direct way to obtain information
about demand is through interviews
where consumers are asked how much
of a product they would be willing to buy
at a given price
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Empirical Estimation of Demand
 Problem
Consumers may lack information or interest,
or be misled by the interviewer
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Empirical Estimation of Demand
 In direct marketing experiments, actual
sales offers are posed to potential
customers and the responses of
customers are observed
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Empirical Estimation of Demand
 The Statistical Approach to Demand
Estimation
Properly applied, the statistical approach to
demand estimation can enable one to sort
out the effects of variables on the quantity
demanded of a product
“Least-squares” regression is one approach
©2005 Pearson Education, Inc.
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Demand Data for Raspberries
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Empirical Estimation of Demand
 Assuming only price determines demand:
Q = a - bP
Q = 28.2 -1.00P
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Estimating Demand
Price 25
D represents demand
if only P determines
demand and then from
the data: Q=28.2-1.00P
20
15
d1
10
d2
5
D
d3
0
5
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15
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25 Quantity
78
Estimating Demand – Changes in
Income
Price
d1, d2, d3 represent the demand for
each income level. Including income
in the demand equation: Q = a - bP +
cI or Q = 8.08 - .49P + .81I
25
20
15
d1
10
d2
5
D
d3
0
5
©2005 Pearson Education, Inc.
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15
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25 Quantity
79
Empirical Estimation of Demand
 Estimating Elasticities
For the demand equation: Q = a - bP
 Elasticity:
E P  (  Q /  P )( P / Q )   b ( P / Q )
©2005 Pearson Education, Inc.
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Empirical Estimation of Demand
 Assuming: Price and income elasticity
are constant
The isoelastic demand =
log( Q )  a  b log( P )  c log( I )
The slope, -b = price elasticity of demand
Constant, c = income elasticity of demand
©2005 Pearson Education, Inc.
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Empirical Estimation of Demand
 Using the Raspberry data:
log( Q )   0 . 81  2 . 4 log( P )  1 . 46 log( I )
Price elasticity = -0.24 (Inelastic)
Income elasticity = 1.46
©2005 Pearson Education, Inc.
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Empirical Estimation of Demand
Complements and Substitutes
log( Q )  a  b log( P )  b 2 log P2  c log( I )
 Substitutes: b2 is positive
 Complements: b2 is negative
©2005 Pearson Education, Inc.
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The Demand for Ready-to-Eat
Cereal
 Are Grape Nuts and Spoon Size
Shredded Wheat good substitutes?
Estimated demand for Grape Nuts (GN)
log( Q GN )  1 . 998  2 . 085 log( PGN )  0 . 62 log( I )  0 . 14 log( PSW )
Price elasticity = -2.0
Income elasticity = 0.62
Cross elasticity = 0.14
©2005 Pearson Education, Inc.
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