Chapter 4 - Individual and market demand

Question 1

Define the price-consumption curve

Answer 1

The price-consumption curve is a curve that goes though points representing market baskets that represent choices a consumer has made. These choices are on “every possible price” of one of the goods.

For instance, if we have food on the x axis and clothing on the y axis: The price-consumption curve looks at where the utility-maximizing choice is located for every different price of food.

The key point in that only one of the goods are changing their price. The other remains constant. This paints of picture of how this relationship is.

Question 2

Elaborate on the individual demand curve

Answer 2

The individual demand curve relates the quantity of a good that a single consumer want to buy to the price of that good.

The individual demand curve has 2 important properties:

1) The level of utility that can be attained changes as we move along the curve. This means, lower price equals higher utility. We can see this with a price reduction. When the price decrease, the budget line shift outward. This means that we/the consumer can reach a higher/better indifference curve.

2) At every point on the individual demand curve, the consumer is maximizing utility by satisfying the condition that the MRS = slope of budget line.

We find the individual demand curve by looking at choices made when one of the goods’ price is constant and the other moves across the space of all possible prices. We relate price to quantity demanded.

The easiest is to use the good which is on the x-axis as the good we keep varying price on. The good on the y axis has a constant price.

Question 3

How does the individual demand curve reflect income boost?

Answer 3

Higher income means that the budget line will shift outward. This means we can reach a better indifference curve.

The higher income will lead to a new/shifted demand curve, like we know from chapter 2.

Question 4

What is the “income-consumption-curve”?

Answer 4

The income consumption curve is basically the same as the price-consumption curve. It maps the relationship between choices made (utility maximizing choices) at different levels of income.

Question 5

what is meant by normal vs inferior goods?

Answer 5

Normal goods: goods that experience increased demand whenever income increase.

Inferior goods: Goods that experience a drop off in regards to demand as income increase. Shitty products that people with to substitute if they can.

Question 6

Though experiment: Can income-consumption curve be non-linear?

Answer 6

Yes. Consider the case where we look at choices made by a consumer (utility maximizing choices) at different levels of income. We consider hamburger on the x axis and steak on y-axis.

One can think that when income is low, one tend to buy much more hamburger than steak, as it is more expensive, and is a substitute in many ways. When income increase to a certain point, we can imagine that the amount of hamburger purchased rise along with the steak as a result of better economic situation. However, as income continue to increase, we can suddenly see hamburger being dropped off significantly, signaling the fact that the consumer can afford always buying steak. This would result in a non-linear income-consumption curve.

Question 7

What are Engel curves?

Answer 7

Engel curves related the quantity of a good consumed to an individual’s income.

We place the good on the x-axis (quantity of the good), and the income level on the y-axis.

The great thing about Engel curves is how they show inferior goods easily. Normal goods will slope upward, while inferior goods will retract and start moving backwards again.

Question 8

Define independent goods

Answer 8

Two goods are independent is a price change of one good has no effect in quantity demanded of the other.

Question 9

How can we determine if two goods are substitutes or complements?

Answer 9

We can use the price consumption curve. Recall that the price consumption curve maps different maximized (utility) choices when the price of the good on the x-axis is changing.

Consider the price-consumption curve: On the downward sloping part, we say that the goods are substitutes.
On the upward sloping part of the price-consumption curve, the goods behave as complements.

Explanation: For a certain income, if the price for food decrease, we buy more of it. At the same time, we reduce the amount we use on clothes.

Question 10

What effects can we say that a fall in price of a good has?

Answer 10

We say a fall in price has 2 effects:

1) Consumers tend to buy more of the good whose price decreased, AND less of other goods that are now relatively more expensive. This is called the “SUBSTITUTION EFFECT”

2) Because one of the goods is now cheaper, consumers can now enjoy more/an increase in real purchasing power. They are now better off because they can buy more amount of good for the same amount of money. This is called the “INCOME EFFECT”.

Question 11

What is the formal definition of “substitution effect”?

Answer 11

The substitution effect is defined as the change in quantity demanded of some good as a result of a price change, with the level of utility held constant.

The substitution effect is marked by movement along the indifference curve.

Question 12

What is the total effect of a price change?

Answer 12

The sum of the substitution effect and the income effect.
They will usually happen at the same time, but if can be useful to distinguish them in order to properly understand the effects.

Question 13

Explain detailed what happens during the a price change, say a price reduction.

Answer 13

We know there are two effects, substitution and income effect.

The substitution effect works as follows:
Formally it is the change in ex food consumption associated with a decrease in price of food, with the level of utility held constant. Food is now relatively cheaper than clothes.
When prices decrease, say the price of the good on the horizontal axis, we will see that the budget line rotate outwards, but remains with the intercept with y-axis constant. This new budget line will intersect and stand tangential to a new “better” indifference curve which increase utility for the consumer. Now, if you want to capture the substitution effect of the price change, we create a new imaginary budget line that is parallel with the other, newly rotated budget line. We then shift this imaginary budget line inwards until it meets the point where it intersect and stands tangential to the same indifference curve as we had before the price change. Because of the rotation due to lower price, the imaginary budget line will not stand tangential at the same point as before the price change, but will be located further along the x-axis, which represent the good that reduced its price. This means that at the very same utility as before, we would have a higher quantity of the good that decreased price and lower amount of the other good. Therefore, the substitution effect tries to capture how a price change will lead to a mix-up in terms of how our market basket look, given constant utility.
THIS SIGNIFIES that even if your level of utility were to remain constant, you’d buy more of the relatively cheaper good and less of the more relatively expensive good.

The INCOME EFFECT:

We use the imaginary line as before. Then we look at how much we can shift the imaginary line forward while it still representing our budget constraints. When we reach the final line, where our budget is fully allocated, we find the point with some indifference curve where the budget line stands tangential. Now, the movement on the x-axis between the points, due to the shift of the budget line, represents the income effect.
Now, the shift is not a result of an actual income increase. It is an illustration of the increase of “real purchasing power”.

So the substitution effect represents how, given the same utility, the amount of good A vs good B change, and the income effect captures how the price change increase utility as well

Question 14

What happens if the income effect is negative?

Answer 14

A negative income effect refers to the fact that the quantity demanded of a good will increase due to the substitution effect, but reduce due to the income effect. This negative pull removes some of the price effect caused by reducing the price. It is typical for inferior goods, which experience a decrease in demand when income increase.

Question 15

What is the Giffen good?

Answer 15

A Giffen good is what we call a good that actually cause the demand curve to slope upward. This is what happens when the income effect is larger than the substitution effect. Only works with inferior goods, and is not very common.

Here’s what happens:

Say I need one coffee every day. My budget allows for 1 good coffee every month, and 29 bad ones. Then let us say that the price of bad coffee increase. I can no longer afford my current basket, so I need to change it. I cant reduce number of bad coffee, as I need one coffee per day. Therefore, I would have to stop buying that one good coffee, which would allow me to buy 30 bad coffees. Therefore, the price increased while my demand also increased, thus the upward sloping demand curve.

Question 16

In a sentance, what is market demand?

Answer 16

Market demand is equal to the sum of all consumer demand

Question 17

Given a table of individual demand at different prices, how do we calculate the market demand?

Answer 17

Market demand is just the sum of all individual demand. This means that we sum up all demand at price x, then price x+1, etc. It is an aggregation.

Question 18

Name factors that should be noted when looking at market demand analysis as sum of individual demand

Answer 18

First, more people/consumers mean more quantity demanded. This means the demand curve will shift to the right as more consumers enter the market. This is fairly natural.

Secondly, factors that influence the demands of many consumers will also affect market demand. For instance, more income for a large group will increase demand. I can imagine that if student loans increased a lot, for instance doubling and doubling the amount of dept free loan, the demand for first price products would probably decrease. This would shift the demand curve.

Question 19

Explain the individual demand curve. Start with choices and price changes. Then go on about the price consumption curve.

Answer 19

Maximized choices are always on a budget line, and stands tangental to an indifference curve which it intersects in only one point. However, if prices were to change, the budget line will change. NB: WE ARE ONLY CONSIDERING PRICE CHANGE OF ONE OF THE GOODS (X -AXIS).

The budget line will rotate outwards or inwards and intersect tangentially with a new indifference curve, with means a new optimized/utility maximized choice is made.

If we keep the price of the good that is on the y-axis constant, and then change the price of the good that is on the x-axis, to very many different prices, and register the choice (utility maximized) for each price, we’d have enough data to make the demand curve. Demand is simply the price-quantity relationship.

Anyways, if we draw a curve between all choices for the varying price levels of the good on the x axis, we’d get the so-called “price-consumption curve”. The price consumption curve simply shows how consumption has varied on different price levels.

Now, if we were to keep track of quantity demanded along with all the prices, we could draw up the individual demand curve for that good.

Question 20

What happens with the consumption of the good on the y-axis as the price of the good on the x-axis decrease?

Answer 20

The price drop increase the consumer’s buying power, which means that he or her can now either buy more of the now cheaper good, more of the good with the constant price, or more of both.

Question 21

regarding the individual demand curve, what properties does it have?

Answer 21

We consider two properties:

1) The level of utility that can be attained changes as we move along the curve. The lower the price, the higher the utility.

2) At every point on the individual demand curve, the consumer is maximizing utility by satisfying the condition that the marginal rate of substitution is equal to the ratio of prices. Recall how to calculate the budget line slope, using I = … and then re-forming it as y = a+bx

Question 22

Consider income changes. What are the effects on the individual demand curve as a result of income changes?

Answer 22

Say we have an income level. We consider prices to be constant. We then draw up the budget line. somewhere on this budget line, the utility maximized choice is made.

Now, what happens if we increase income? Because the ratio of prices determine the slope of the budget line, this would not change. However, the intercept would. Therefore, the entire budget line would shift OUT. On the newly shifted budget line, a new utility maximized choice is made.
If we do this many times, we get many choices, choices at varying income levels. We can use these choices to draw a curve, called the income-consumption curve.

What happens to the individual demand curve in this case? As before, we can plot a point the tracks quantity demanded for each income level. But, since price is constant, we dont actually “fill out the demand curve”. What we actually see, is shifts in demand curve.

Question 23

Define normal goods

Answer 23

Normal goods are goods that experience increased demand whenever the income level increase.

In other words, the income-elasticity of demand is positive.

Question 24

Define inferior goods

Answer 24

Inferior goods have negative income-elasticity of demand. Meaning, the quantity demanded will decrease as a result of an income increase. Goods include shitty products such as burger, first price, HM clothes.

Question 25

What is a really quick way of defining price-consumption curves and income-consumption curves?

Answer 25

We vary levels of the first term (price or income) and look at what happens to consumption / demand.

Question 26

What happens when the price of a good falls? what are the effects of such price fall?

Answer 26

We say a price decrease/fall has 2 types of effect:

1) Consumers tend to buy more when a price fall, since we can now buy more of it. ALSO, we as consumers tend to buy less of the good that has become relatively more expensive as a result of the other good decreasing its price. This is called the substitution effect.

2) Lower price of one good means increased real purchasing power. This means we can buy the same amount of goods as before and have more money left. This is called the income effect.

These two effects happen at the same time. However, it is important to understand them separately.

Question 27

Elaborate on the substitution effect

Answer 27

Say the price of food change. The price of food falls.

The substitution effect is the change in demand of food associated with a change in price of food, WHEN the level of utility is held constant.

Because we are looking at constant utility, we are looking at what happens to the market basket now that the prices are different. Since we are at constant utility, we are still considering the very same indifference curve as before. This means, the new market basket, which will be corresponding to a utility maximized choice in regards to the new prices will be somewhere on the same indifference curve. The rules regarding MRS and tangents are still the same. The thing is that the budget line has now changed. It has rotated outwards (inwards if price increase). Then the budget line is shifted down to the indifference curve, and we get the new choice.

The main point is this: If price of food drops, consumers will tend to buy more of food, and less of clothes, or whatever is the other good. This is reflected on the market basket which shows the combination. Since lower price of food = tendency to buy more food, the new choice is more to the right. In addition, since the price drop of food is followed by the tendency to buy less of the other good, the new choice will also be lower than the previous, in regards to the good on the y-axis.

Summary: Price changes causes new combinations of goods to create the same level of utility as before.

Question 28

Elaborate on the income effect

Answer 28

Formal definition: The income effect is the change in food consumption (or another good on the x-axis) brought about by an increase in purchasing power, with relative prices held constant.

The income effect is essentially just what happens if we were to increase our income. We would buy more of both goods. Causing a shift of the budget line. Shift outwards, new indifference curve. Higher utility.

It is worth recalling what happens when the good of interest is an inferior good. Because it is inferior, as we increase income, the demand of the good will actually drop, shifting the budget line inwards instead.

Question 29

Market demand is rather easy, but what points should be noted in regards to creating a market demand curve from several individual demand curves?

Answer 29

1) The demand curve will shift to the right as more consumers enter the market demand curve

2) Factors that influence the demand of groups of consumers will naturally also influence the market demand curve.

Question 30

How can we use market demand curves to our benefit?

Answer 30

Many ways. One of them is to understand certain groups of people better. This helps us understand our market. For instance, we can create a market demand curve for computers that only include students, etc.

Question 31

Define elastic demand, inelastic demand

Answer 31

inelastic demand is unresponsive markets. We might increase the price, but see a lower relative change in quantity demanded. This means that total expenditure on the product increase as we increase the price.

When demand is elastic, a price change is accompanied by an even larger change in demand. This means that if price increase total expenditure will go down.

Very important concepts to understand demand.

Question 32

What is constant elasticity of demand?

Answer 32

We call it isoelastic demand. Note that constant can mean anything, only that it remains the same.

We can also have constant equal -1. I that case, we call it “unit elastic demand”. In such cases, total expenditure remains the same regardless of price.

Question 33

Elaborate on speculative demand

Answer 33

Sometimes, perhaps even often, irrational.

We refer to speculative demand as demand where we dont buy goods and services to consume, but as a gamble to sell later at a profit.

Question 34

Define the shape of demand curve for both elastic and inelastic demand

Answer 34

Elastic price elasticity of demand will create a demand curve that is flat. Not entire flat, but flatter than other cases. This allows a small change in price to cause a large change in quantity demanded.

Inelastic demand create a demand curve that is much steeper. We can change the price a lot without causing too much movement on the curve.

Question 35

The Toal effect of a price change is the sum of the income effect and substitution effect. What happens when the income effect is negative, why does this happen?

Answer 35

Inferior goods have a negative income effect. This is because as income increase their demand decrease (definition of inferior good). This negative income effect will counter some of the price change effect overall.

If the income effect is large enough to counter the entire substitution effect so that the overall price change effect becomes negative, then we have a “giffen good”. This will cause the demand curve to slope upward.

Question 36

What is consumer surplus?

Answer 36

The difference in what a consumer is maximum willing to pay, and what he actually pays.

Consumer surplus is an individual thing because of the fact that we are different and place different values on different goods.

Question 37

What is aggregate consumer surplus?

Answer 37

When we add all of the surplus’ together we get aggregate consumer surplus. Remember that consumers have different limits for how much they are willing to pay. Therefore this amount will vary.

Question 38

Given a demand curve, how can we calculate consumer surplus?

Answer 38

We need a market price line that is placed on the demand curve so that it splits up the area under the demand curve into parts. The point where the market price line intersects the demand curve represents the limit in regards to where we no longer get any surplus from buying, but rather loose money.

To the left of the separation between the money sone and the no money zone, the area under the market price line represents actual expenditure. The area above represents the surplus.

Question 39

How do we find the consumer surplus given a demand curve, a market price line?

Answer 39

Integrate from 0 to the point where the market price meets the demand curve, and then subtract the amount which is the expenditure.

Question 40

What is a network externality?

Answer 40

A network externality refers to the fact that a consumer’s demand is affected by the demand of other people/consumers.

We have both positive and negative network externalities. Positive network externalities refer to the fact that the quantity demanded for some good increase as the growth increases for other consumers, and negative is the opposite: demand grows if there are less people interested. Ex ski lifts.

Question 41

What is the bandwagon effect?

Answer 41

Positive network externalities. People want to be in style, and therefore the demand will grow when the amount of people interested grow.

Question 42

Regarding positive network externalities, consider different levels of volume bought: How would this impact demand curve?

Answer 42

The demand curve would shift because of externalities effect.

Question 43

How do we find the market demand curve from different levels of demand curves that show externalities effect?

Answer 43

By joining the points on the individual curves together.

Question 44

Does positive externality lead to inelastic or elastic demand?

Answer 44

More elastic.

Question 45

Define Laspeyres index

Answer 45

Laspeyres index considers some good at a base year, along with the price of that good in this base year, and then looks at what it requires to buy the same quantity of that good in some later year.

More specifically, we sum together, for the different goods, the quantity weight (of good in base year) multiplied with price in current year. Then we divide all of this on the same thing, but with price in base year as well.

LI = (PriceNowQuantityBase)/(PriceBaseQuantityBase)

Question 46

Define Paasche index

Answer 46

Paasche index uses quantities in the current year as weights.

Therefore, the Paasche index is the amount of money in current year prices that a consumer would need to be able to buy current bundle of goods DIVIDED by the price (in base price) multiplied by the same quantity.

Question 47

What is the Fischer index?

Answer 47

The fisher index is the geometric average of LI and PI.

FI = sqrt(LI*PI)

Question 48

Name the formula of consumer surplus

Answer 48

Integral(P(Q)dQ))[0,q_0]

Question 49

WHat is the relationship between demand curve of a single consumer and utility?

Answer 49

Since movement along the demand curve gives the relationship between how much a consumer will buy given some price, we can easily see that utility increase as price decrease.

We can also note that at every single point on the demand curve, we know that the consumer is maximizing utility.

Question 50

Elaborate on the difference between Paasche index and Laspeyres index

Answer 50

Laspeyres use quantitites in base year, while Paasche use quantities in current year.

This means that the formulas are like this:

LI = SUM(P_c * X_b})/ SUM(P_b * X_b)

PI = SUM(P_c * X_c)/SUM(P_b * X_c)

These cost-of-living indices does not take into account that as prices change, the relative amount of both goods change as well.

Question 51

Define an ideal cost of living index

Answer 51

The ideal cost of living index would capture the cost of attaining some specific level of utility VS the cost of attaining the same utility at another time. We place the cost of current year prices at the numerator, and the cost of base year in the denominator.