Econ Chapter 4.pdf

CHAPTER 4 individual and market Demand C hapter 3 laid the foundation for the theory of consumer de- CHAPTER oUTLiNE mand. We discussed the nature of consumer preferences and saw how, given budget constraints, consumers choose market 4.1 individual Demand...

CHAPTER 4 individual and market Demand C hapter 3 laid the foundation for the theory of consumer de- CHAPTER oUTLiNE mand. We discussed the nature of consumer preferences and saw how, given budget constraints, consumers choose market 4.1 individual Demand 132 baskets that maximize utility. From here it’s a short step to analyz- 4.2 income and Substitution ing demand and showing how the demand for a good depends on its Effects 139 price, the prices of other goods, and income. 4.3 market Demand 144 Our analysis of demand proceeds in six steps: 4.4 Consumer Surplus 152 1. We begin by deriving the demand curve for an individual con- 4.5 Network Externalities 155 sumer. Because we know how changes in price and income af- *4.6 Empirical Estimation of fect a person’s budget line, we can determine how they affect Demand 159 consumption choice. We will use this information to see how the Appendix: Demand quantity of a good demanded varies in response to price changes Theory—A mathematical as we move along an individual’s demand curve. We will also Treatment 169 see how this demand curve shifts in response to changes in the individual’s income. 2. With this foundation, we will examine the effect of a price change LiST oF ExAmPLES in more detail. When the price of a good goes up, individual de- 4.1 Consumer Expenditures mand for it can change in two ways. First, because it has now in the United States 137 become more expensive relative to other goods, consumers will 4.2 The Effects of a buy less of it and more of other goods. Second, the higher price Gasoline Tax 142 reduces the consumer’s purchasing power. This reduction is just 4.3 The Aggregate Demand like a reduction in income and will lead to a reduction in con- for Wheat 148 sumer demand. By analyzing these two distinct effects, we will better understand the characteristics of demand. 4.4 The Demand for Housing 149 3. Next, we will see how individual demand curves can be aggre- 4.5 The Long-Run Demand for Gasoline 151 gated to determine the market demand curve. We will also study the characteristics of market demand and see why the demands 4.6 The Value of Clean Air 154 for some kinds of goods differ considerably from the demands 4.7 Facebook versus for others. Google Plus 158 4. We will go on to show how market demand curves can be used 4.8 The Demand for to measure the benefits that people receive when they consume Ready-to-Eat Cereal 162 products, above and beyond the expenditures they make. This information will be especially important later, when we study the effects of government intervention in a market. 5. We then describe the effects of network externalities—i.e., what happens when a person’s demand for a good also depends on 131  132 PART 2 Producers, Consumers, and Competitive markets the demands of other people. These effects play a crucial role in the de- mands for many high-tech products, such as computer hardware and soft- ware, and telecommunications systems. 6. Finally, we will briefly describe some of the methods that economists use to obtain empirical information about demand. 4.1 Individual Demand This section shows how the demand curve of an individual consumer follows from the consumption choices that a person makes when faced with a budget constraint. To illustrate these concepts graphically, we will limit the available goods to food and clothing, and we will rely on the utility-maximization ap- proach described in Section 3.3 (page 108). Price Changes In §3.3, we explain how We begin by examining ways in which the consumption of food and clothing a consumer chooses changes when the price of food changes. Figure 4.1 shows the consumption the market basket on the choices that a person will make when allocating a fixed amount of income be- highest indifference curve tween the two goods. that touches the consumer’s budget line. Initially, the price of food is $1, the price of clothing $2, and the consum- er’s income $20. The utility-maximizing consumption choice is at point B in Figure 4.1 (a). Here, the consumer buys 12 units of food and 4 units of clothing, thus achieving the level of utility associated with indifference curve U2. Now look at Figure 4.1 (b), which shows the relationship between the price of food and the quantity demanded. The horizontal axis measures the quantity of food consumed, as in Figure 4.1 (a), but the vertical axis now measures the price of food. Point G in Figure 4.1 (b) corresponds to point B in Figure 4.1 (a). At G, the price of food is $1, and the consumer purchases 12 units of food. In §3.2, we explain how Suppose the price of food increases to $2. As we saw in Chapter 3, the budget the budget line shifts in line in Figure 4.1 (a) rotates inward about the vertical intercept, becoming twice response to a price change. as steep as before. The higher relative price of food has increased the magnitude of the slope of the budget line. The consumer now achieves maximum utility at A, which is found on a lower indifference curve, U1. Because the price of food has risen, the consumer’s purchasing power—and thus attainable utility—has fallen. At A, the consumer chooses 4 units of food and 6 units of clothing. In Figure 4.1 (b), this modified consumption choice is at E, which shows that at a price of $2, 4 units of food are demanded. Finally, what will happen if the price of food decreases to 50 cents? Because the budget line now rotates outward, the consumer can achieve the higher level of utility associated with indifference curve U3 in Figure 4.1 (a) by selecting D, with 20 units of food and 5 units of clothing. Point H in Figure 4.1 (b) shows the price of 50 cents and the quantity demanded of 20 units of food. The Individual Demand Curve We can go on to include all possible changes in the price of food. In Figure 4.1 (a), price-consumption the price-consumption curve traces the utility-maximizing combinations of curve Curve tracing the utility- maximizing combinations of two food and clothing associated with every possible price of food. Note that as the goods as the price of one changes. price of food falls, attainable utility increases and the consumer buys more food.  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 133 This pattern of increasing consumption of a good in response to a decrease in price almost always holds. But what happens to the consumption of clothing as the price of food falls? As Figure 4.1 (a) shows, the consumption of clothing may either increase or decrease. The consumption of both food and clothing can increase because the decrease in the price of food has increased the consumer’s ability to purchase both goods. An individual demand curve relates the quantity of a good that a single individual demand consumer will buy to the price of that good. In Figure 4.1 (b), the individual de- curve Curve relating the quantity of a good that a single mand curve relates the quantity of food that the consumer will buy to the price consumer will buy to its price. of food. This demand curve has two important properties: 1. The level of utility that can be attained changes as we move along the curve. The lower the price of the product, the higher the level of utility. Note from Figure 4.1 (a) that a higher indifference curve is reached as the price falls. Again, this result simply reflects the fact that as the price of a product falls, the consumer’s purchasing power increases. Clothing (units per month) U1 A Price-Consumption Curve 6 5 D B 4 U3 U2 FIgure 4.1 EffEct of PricE changEs 4 12 20 Food (units A reduction in the price of food, with income and the per month) (a) price of clothing fixed, causes this consumer to choose Price a different market basket. In (a), the baskets that maxi- of food mize utility for various prices of food (point A, $2; B, $1; E D, $0.50) trace out the price-consumption curve. Part $2.00 (b) gives the demand curve, which relates the price of food to the quantity demanded. (Points E, G, and H correspond to points A, B, and D, respectively). 1.50 Demand Curve 1.00 G 0.50 H 4 12 20 Food (units per month) (b)  134 PART 2 Producers, Consumers, and Competitive markets 2. At every point on the demand curve, the consumer is maximizing utility In §3.1, we introduce the by satisfying the condition that the marginal rate of substitution (MRS) marginal rate of substitution (MRS) as a measure of the of food for clothing equals the ratio of the prices of food and clothing. As maximum amount of one the price of food falls, the price ratio and the MRS also fall. In Figure 4.1 good that the consumer is (b), the price ratio falls from 1 ($2/$2) at E (because the curve U1 is tan- willing to give up in order to obtain one unit of another gent to a budget line with a slope of -1 at A) to 1/2 ($1/$2) at G, to 1/4 good. ($0.50/$2) at H. Because the consumer is maximizing utility, the MRS of food for clothing decreases as we move down the demand curve. This phenomenon makes intuitive sense because it tells us that the relative value of food falls as the consumer buys more of it. The fact that the MRS varies along the individual’s demand curve tells us something about how consumers value the consumption of a good or service. Suppose we were to ask a consumer how much she would be willing to pay for an additional unit of food when she is currently consuming 4 units. Point E on the demand curve in Figure 4.1 (b) provides the answer: $2. Why? As we pointed out above, because the MRS of food for clothing is 1 at E, one additional unit of food is worth one additional unit of clothing. But a unit of clothing costs $2, which is, therefore, the value (or marginal benefit) obtained by consum- ing an additional unit of food. Thus, as we move down the demand curve in Figure 4.1 (b), the MRS falls. Likewise, the value that the consumer places on an additional unit of food falls from $2 to $1 to $0.50. Income Changes We have seen what happens to the consumption of food and clothing when the price of food changes. Now let’s see what happens when income changes. The effects of a change in income can be analyzed in much the same way as a price change. Figure 4.2 (a) shows the consumption choices that a consumer will make when allocating a fixed income to food and clothing when the price of food is $1 and the price of clothing $2. As in Figure 4.1 (a), the quantity of clothing is measured on the vertical axis and the quantity of food on the horizontal axis. Income changes appear as changes in the budget line in Figure 4.2 (a). Initially, the consumer’s income is $10. The utility-maximizing consumption choice is then at A, at which point she buys 4 units of food and 3 units of clothing. This choice of 4 units of food is also shown in Figure 4.2 (b) as E on demand curve D1. Demand curve D1 is the curve that would be traced out if we held income fixed at $10 but varied the price of food. Because we are holding the price of food constant, we will observe only a single point E on this demand curve. What happens if the consumer’s income is increased to $20? Her budget line then shifts outward parallel to the original budget line, allowing her to attain the utility level associated with indifference curve U2. Her optimal consump- tion choice is now at B, where she buys 10 units of food and 5 units of clothing. In Figure 4.2 (b) her consumption of food is shown as G on demand curve D2. D2 is the demand curve that would be traced out if we held income fixed at $20 but varied the price of food. Finally, note that if her income increases to $30, she chooses D, with a market basket containing 16 units of food (and 7 units of clothing), represented by H in Figure 4.2 (b). We could go on to include all possible changes in income. In Figure 4.2 (a), income-consumption the income-consumption curve traces out the utility-maximizing combinations curve Curve tracing the utility- of food and clothing associated with every income level. The income-consump- maximizing combinations of two goods as a consumer’s income tion curve in Figure 4.2 slopes upward because the consumption of both food changes. and clothing increases as income increases. Previously, we saw that a change in the price of a good corresponds to a movement along a demand curve. Here, the  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 135 Clothing (units per month) Income-Consumption Curve 7 D U3 5 U2 B 3 U1 A 4 10 16 Food (units FIgure 4.2 per month) EffEct of incomE changEs (a) An increase in income, with the prices of all goods fixed, causes Price consumers to alter their choice of market baskets. In part (a), the of food baskets that maximize consumer satisfaction for various incomes (point A, $10; B, $20; D, $30) trace out the income-consumption curve. The shift to the right of the demand curve in response to E G H the increases in income is shown in part (b). (Points E, G, and H $1.00 correspond to points A, B, and D, respectively.) D3 D2 D1 4 10 16 Food (units (b) per month) situation is different. Because each demand curve is measured for a particular level of income, any change in income must lead to a shift in the demand curve itself. Thus A on the income-consumption curve in Figure 4.2 (a) corresponds to E on demand curve D1 in Figure 4.2 (b); B corresponds to G on a different demand curve D2. The upward-sloping income-consumption curve implies that an increase in income causes a shift to the right in the demand curve—in this case from D1 to D2 to D3. Normal versus Inferior goods When the income-consumption curve has a positive slope, the quantity de- In §2.4, we explain that the manded increases with income. As a result, the income elasticity of demand is income elasticity of demand positive. The greater the shifts to the right of the demand curve, the larger the is the percentage change in the quantity demanded income elasticity. In this case, the goods are described as normal: Consumers resulting from a 1-percent want to buy more of them as their incomes increase. increase in income. In some cases, the quantity demanded falls as income increases; the income elasticity of demand is negative. We then describe the good as inferior. The term inferior simply means that consumption falls when income rises. Hamburger, for example, is inferior for some people: As their income increases, they buy less hamburger and more steak.  136 PART 2 Producers, Consumers, and Competitive markets 15 Steak (units per Income-Consumption month) Curve FIgure 4.3 C an infErior good 10 An increase in a person’s income can U3 lead to less consumption of one of the two goods being purchased. Here, ham- burger, though a normal good between 5 B A and B, becomes an inferior good when the income-consumption curve bends backward between B and C. U2 A U1 5 10 20 30 Hamburger (units per month) Figure 4.3 shows the income-consumption curve for an inferior good. For relatively low levels of income, both hamburger and steak are normal goods. As income rises, however, the income-consumption curve bends backward (from point B to C). This shift occurs because hamburger has become an inferior good—its consumption has fallen as income has increased. engel Curves Engel curve Curve relating the Income-consumption curves can be used to construct Engel curves, which quantity of a good consumed to relate the quantity of a good consumed to an individual’s income. Figure 4.4 income. shows how such curves are constructed for two different goods. Figure 4.4 (a), Income Income (dollars per 30 (dollars per 30 month) month) Inferior Engel Curve 20 20 Normal 10 10 0 4 8 12 16 0 5 10 Food (units Hamburger (units per month) per month) (a) (b) FIgure 4.4 EngEl curvEs Engel curves relate the quantity of a good consumed to income. In (a), food is a normal good and the Engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month.  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 137 which shows an upward-sloping Engel curve, is derived directly from Figure 4.2 (a). In both figures, as the individual’s income increases from $10 to $20 to $30, her consumption of food increases from 4 to 10 to 16 units. Recall that in Figure 4.2 (a) the vertical axis measured units of clothing consumed per month and the horizontal axis units of food per month; changes in income were reflected as shifts in the budget line. In Figures 4.4 (a) and (b), we have replotted the data to put income on the vertical axis, while keeping food and hamburger on the horizontal. The upward-sloping Engel curve in Figure 4.4 (a)—like the upward-sloping income-consumption curve in Figure 4.2 (a)—applies to all normal goods. Note that an Engel curve for clothing would have a similar shape (clothing consump- tion increases from 3 to 5 to 7 units as income increases). Figure 4.4 (b), derived from Figure 4.3, shows the Engel curve for hamburger. We see that hamburger consumption increases from 5 to 10 units as income in- creases from $10 to $20. As income increases further, from $20 to $30, consump- tion falls to 8 units. The portion of the Engel curve that slopes downward is the income range within which hamburger is an inferior good. examPle 4.1 consumEr ExPEnditurEs in thE unitEd statEs The Engel curves we just exam- describing the expenditures of a ined apply to individual consum- typical family. ers. However, we can also derive Note that the data relate expendi- Engel curves for groups of con- tures on a particular item rather than sumers. This information is partic- the quantity of the item to income. ularly useful if we want to see how The first two items, entertainment consumer spending varies among and owned dwellings, are consump- different income groups. Table 4.1 tion goods for which the income illustrates spending patterns for elasticity of demand is high. Average several items taken from a survey by the U.S. Bureau family expenditures on entertainment increase almost of Labor Statistics. Although the data are averaged fivefold when we move from the lowest to highest in- over many households, they can be interpreted as come group. The same pattern applies to the purchase Table 4.1 annual u.s. housEhold consumEr ExPEnditurEs IncoMe GRoup expendItuReS LeSS than 10,000– 20,000– 30,000– 40,000– 50,000– 70,000 and ($) on: $10,000 19,999 29,999 39,999 49,999 69,999 above entertainment 1,038 1,165 1,407 1,969 2,131 2,548 4,655 owned dwelling 1,770 2,134 2,795 3,581 4,198 5,556 11,606 Rented dwelling 3,919 3,657 4,054 3,878 4,273 3,812 3,072 health care 1,434 2,319 3,124 3,539 3,709 4,702 6,417 Food 3,466 3,706 4,432 5,194 5,936 6,486 10,116 clothing 798 766 960 1,321 1,518 1,602 2,928 Source: u.S. department of Labor, bureau of Labor Statistics, “consumer expenditure Survey, annual Report 2015.”  138 PART 2 Producers, Consumers, and Competitive markets of homes: There is a more than a sixfold increase in elasticities are positive, but not as high as for enter- expenditures from the lowest to the highest category. tainment or owner-occupied housing. in contrast, expenditures on rental housing ac- The data in Table 4.1 for rented dwellings, health tually fall as income rises. This pattern reflects the care, and entertainment have been plotted in fact that most higher-income individuals own rather Figure 4.5. observe in the three Engel curves that than rent homes. Thus rental housing is an inferior as income rises, expenditures on entertainment and good, at least for incomes above $40,000 per year. health care increase rapidly, while expenditures on Finally, note that health care, food, and cloth- rental housing increase when income is low, but de- ing are consumption items for which the income crease once income exceeds $40,000. $80,000 $70,000 $60,000 FIgure 4.5 EngEl curvEs for u.s. $50,000 Annual Income consumErs Average per-household $40,000 expenditures on rented dwellings, health care, $30,000 and entertainment are plotted as functions of annual income. Health $20,000 care and entertainment are normal goods, as ex- penditures increase with $10,000 income. Rental housing, however, is an inferior good for incomes above $0 $40,000. $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 Annual Expenditure Entertainment Rented Dwelling Health Care Substitutes and Complements The demand curves that we graphed in Chapter 2 showed the relationship between the price of a good and the quantity demanded, with preferences, income, and the prices of all other goods held constant. For many goods, de- mand is related to the consumption and prices of other goods. Baseball bats and baseballs, hot dogs and mustard, and computer hardware and software are all examples of goods that tend to be used together. Other goods, such as cola and diet cola, owner-occupied houses and rental apartments, movie tickets and movie rentals, tend to substitute for one another. Recall from Section 2.1 (page 44) that two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other.  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 139 If the price of a movie ticket rises, we would expect individuals to rent more movies, because movie tickets and movie rentals are substitutes. Similarly, two goods are complements if an increase in the price of one good leads to a decrease in the quantity demanded of the other. If the price of gasoline goes up, causing gasoline consumption to fall, we would expect the consumption of motor oil to fall as well, because gasoline and motor oil are used together. Two goods are independent if a change in the price of one good has no effect on the quantity demanded of the other. One way to see whether two goods are complements or substitutes is to examine the price-consumption curve. Look again at Figure 4.1 (page 133). Note that in the downward-sloping portion of the price-consumption curve, food and clothing are substitutes: The lower price of food leads to a lower consump- tion of clothing (perhaps because as food expenditures increase, less income is available to spend on clothing). Similarly, food and clothing are complements in the upward-sloping portion of the curve: The lower price of food leads to higher clothing consumption (perhaps because the consumer eats more meals at restaurants and must be suitably dressed). The fact that goods can be complements or substitutes suggests that when studying the effects of price changes in one market, it may be important to look at the consequences in related markets. (Interrelationships among markets are discussed in more detail in Chapter 16.) Determining whether two goods are complements, substitutes, or independent goods is ultimately an empirical question. To answer the question, we need to look at the ways in which the de- mand for the first good shifts (if at all) in response to a change in the price of the second. This question is more difficult than it sounds because lots of things are likely to be changing at the same time that the price of the first good changes. In fact, Section 4.6 of this chapter is devoted to examining ways to distinguish empirically among the many possible explanations for a change in the demand for the second good. First, however, it will be useful to undertake a basic theo- retical exercise. In the next section, we delve into the ways in which a change in the price of a good can affect consumer demand. 4.2 Income and Substitution effects A fall in the price of a good has two effects: 1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. This re- sponse to a change in the relative prices of goods is called the substitution effect. 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. They are better off because they can buy the same amount of the good for less money, and thus have money left over for ad- ditional purchases. The change in demand resulting from this change in real purchasing power is called the income effect. Normally, these two effects occur simultaneously, but it will be useful to distinguish between them for purposes of analysis. The specifics are illustrated in Figure 4.6, where the initial budget line is RS and there are two goods, food and clothing. Here, the consumer maximizes utility by choosing the market basket at A, thereby obtaining the level of utility associated with the indiffer- ence curve U1.  140 PART 2 Producers, Consumers, and Competitive markets Clothing (units per FIgure 4.6 month) R incomE and substitution EffEcts: normal good A decrease in the price of food has both an income effect and a substitution effect. The A consumer is initially at A, on budget line RS. C1 When the price of food falls, consumption in- creases by F1F2 as the consumer moves to B. B The substitution effect F1E (associated with a C2 move from A to D) changes the relative prices D U2 of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 U1 (associated with a move from D to B) keeps relative prices constant but increases purchas- O F1 E S F2 T Food ing power. Food is a normal good because the (units per Substitution Income month) income effect EF2 is positive. Effect Effect Total Effect Now let’s see what happens if the price of food falls, causing the budget line to rotate outward to line RT. The consumer now chooses the market basket at B on indifference curve U2. Because market basket B was chosen even though market basket A was feasible, we know (from our discussion of revealed prefer- ence in Section 3.4) that B is preferred to A. Thus, the reduction in the price of In §3.4, we show how infor- food allows the consumer to increase her level of satisfaction—her purchasing mation about consumer power has increased. The total change in the consumption of food caused by preferences is revealed by the lower price is given by F1F2. Initially, the consumer purchased OF1 units of consumption choices made. food, but after the price change, food consumption has increased to OF2. Line segment F1F2, therefore, represents the increase in desired food purchases. Substitution effect The drop in price has both a substitution effect and an income effect. The substitution effect Change substitution effect is the change in food consumption associated with a change in the in consumption of a good price of food, with the level of utility held constant. The substitution effect captures associated with a change in its price, with the level of utility held the change in food consumption that occurs as a result of the price change that constant. makes food relatively cheaper than clothing. This substitution is marked by a movement along an indifference curve. In Figure 4.6, the substitution effect can be obtained by drawing a budget line which is parallel to the new budget line RT (reflecting the lower relative price of food), but which is just tangent to the original indifference curve U1 (holding the level of satisfaction constant). The new, lower imaginary budget line reflects the fact that nominal income was reduced in order to accomplish our conceptual goal of isolating the substitu- tion effect. Given that budget line, the consumer chooses market basket D and consumes OE units of food. The line segment F1E thus represents the substitu- tion effect. Figure 4.6 makes it clear that when the price of food declines, the substitu- tion effect always leads to an increase in the quantity of food demanded. The  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 141 explanation lies in the fourth assumption about consumer preferences dis- cussed in Section 3.1—namely, that indifference curves are convex. Thus, with the convex indifference curves shown in the figure, the point that maximizes satisfaction on the new imaginary budget line parallel to RT must lie below and to the right of the original point of tangency. Income effect Now let’s consider the income effect: the change in food consumption brought income effect Change in about by the increase in purchasing power, with relative prices held constant. In consumption of a good resulting from an increase in purchasing Figure 4.6, we can see the income effect by moving from the imaginary budget power, with relative prices held line that passes through point D to the parallel budget line, RT, which passes constant. through B. The consumer chooses market basket B on indifference curve U2 (because the lower price of food has increased her level of utility). The increase in food consumption from OE to OF2 is the measure of the income effect, which is positive, because food is a normal good (consumers will buy more of it as their incomes increase). Because it reflects a movement from one indifference curve to another, the income effect measures the change in the consumer’s purchasing power. We have seen in Figure 4.6 that the total effect of a change in price is given theoretically by the sum of the substitution effect and the income effect: Total Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2) Recall that the direction of the substitution effect is always the same: A de- cline in price leads to an increase in consumption of the good. However, the income effect can move demand in either direction, depending on whether the good is normal or inferior. A good is inferior when the income effect is negative: As income rises, con- inferior good A good that has sumption falls. Figure 4.7 shows income and substitution effects for an inferior a negative income effect. good. The negative income effect is measured by line segment EF2. Even with Clothing (units per month) R FIgure 4.7 incomE and substitution EffEcts: infErior good The consumer is initially at A on budget line B RS. With a decrease in the price of food, the A consumer moves to B. The resulting change in food purchased can be broken down into a sub- stitution effect, F1E (associated with a move from U2 A to D), and an income effect, EF2 (associated D with a move from D to B). In this case, food is an inferior good because the income effect is nega- U1 tive. However, because the substitution effect exceeds the income effect, the decrease in the O F1 F2 E S T Food (units per price of food leads to an increase in the quantity Substitution month) of food demanded. Effect Income Effect Total Effect  142 PART 2 Producers, Consumers, and Competitive markets Clothing (units per month) FIgure 4.8 uPward-sloPing dEmand B curvE: thE giffEn good When food is an inferior good, and when the income effect is large enough to domi- U2 nate the substitution effect, the demand A curve will be upward-sloping. The consumer D is initially at point A, but, after the price of food falls, moves to B and consumes U1 less food. Because the income effect EF2 is larger than the substitution effect F1E, the decrease in the price of food leads to a lower quantity of food demanded. O F2 F 1 E Food (units Substitution Effect per month) Income Effect Total Effect inferior goods, the income effect is rarely large enough to outweigh the substi- tution effect. As a result, when the price of an inferior good falls, its consump- tion almost always increases. a Special Case: The giffen good Theoretically, the income effect may be large enough to cause the demand curve Giffen good Good whose for a good to slope upward. We call such a good a Giffen good, and Figure 4.8 demand curve slopes upward shows its income and substitution effects. Initially, the consumer is at A, con- because the (negative) income effect is larger than the suming relatively little clothing and much food. Now the price of food declines. substitution effect. The decline in the price of food frees enough income so that the consumer de- sires to buy more clothing and fewer units of food, as illustrated by B. Revealed preference tells us that the consumer is better off at B rather than A even though less food is consumed. Though intriguing, the Giffen good is rarely of practical interest because it requires a large negative income effect. But the income effect is usually small: Individually, most goods account for only a small part of a consumer’s budget. Large income effects are often associated with normal rather than inferior goods (e.g., total spending on food or housing). examPle 4.2 thE EffEcts of a gasolinE tax in part to conserve energy and in part to raise rev- important goal of higher gasoline taxes is to dis- enues, the U.S. government has often considered courage gasoline consumption, the government increasing the federal gasoline tax. in 1993, for has also considered ways of passing the resulting example, a modest 4.3 cent increase was enacted income back to consumers. one popular sugges- as part of a larger budget-reform package. This tion is a rebate program in which tax revenues increase was much less than the increase that would be returned to households on an equal per- would have been necessary to put U.S. gasoline capita basis. What would be the effect of such a prices on a par with those in Europe. Because an program?  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 143 Let’s begin by focusing on the effect of the pro- gallon, price will increase by 50 percent, shifting gram over a period of five years. The relevant price the new budget line to AD.2 (Recall that when price elasticity of demand is about -0.5.1 Suppose that a changes and income stays fixed, the budget line low-income consumer uses about 1200 gallons of rotates around a pivot point on the unchanged axis.) gasoline per year, that gasoline costs $1 per gallon, With a price elasticity of -0.5, consumption will and that our consumer’s annual income is $9000. decline 25 percent, from 1200 to 900 gallons, as Figure 4.9 shows the effect of the gasoline tax. shown by the utility-maximizing point E on indiffer- (The graph has intentionally been drawn not to ence curve U1 (for every 1-percent increase in the scale so that the effects we are discussing can be price of gasoline, quantity demanded drops by 1/2 seen more clearly.) The original budget line is AB, percent). and the consumer maximizes utility (on indiffer- The rebate program, however, partially counters ence curve U2) by consuming the market basket at this effect. Suppose that because the tax revenue C, buying 1200 gallons of gasoline and spending per person is about $450(900 gallons times 50 cents $7800 on other goods. if the tax is 50 cents per per gallon), each consumer receives a $450 rebate. F After Gasoline Tax Plus Rebate A Expenditures on other goods ($) H C After E Gasoline Tax U2 Original Budget U1 Line 900 913.5 1200 D J B Gasoline consumption (gallons per year) FIgure 4.9 EffEct of a gasolinE tax with a rEbatE A gasoline tax is imposed when the consumer is initially buying 1200 gallons of gasoline at point C. After the tax takes effect, the budget line shifts from AB to AD and the consumer maximizes his preferences by choosing E, with a gasoline consumption of 900 gallons. However, when the proceeds of the tax are rebated to the consumer, his consumption increases somewhat, to 913.5 gallons at H. Despite the rebate program, the consumer’s gasoline consumption has fallen, as has his level of satisfaction. 1 We saw in Chapter 2 that the price elasticity of demand for gasoline varies substantially from the short run to the long run. 2 To simplify the example, we have assumed that the entire tax is paid by consumers in the form of a higher price. A broader analysis of tax shifting is presented in Chapter 9.  144 PART 2 Producers, Consumers, and Competitive markets How does this increased income affect gasoline the program is an increase in income. During the consumption? The effect can be shown graphically second year, it would lead to some increase in gaso- by shifting the budget line upward by $450, to line line consumption among the low-income consumers FJ, which is parallel to AD. How much gasoline that we are studying. With increased consumption, does our consumer buy now? in Chapter 2, we saw however, the tax paid and the rebate received by that the income elasticity of demand for gasoline an individual will increase in the second year. As is approximately 0.3. Because $450 represents a a result, it may be difficult to predict the size of the 5-percent increase in income ($450/$9000 = 0.05), program budget. we would expect the rebate to increase consumption Figure 4.9 reveals that the gasoline tax program by 1.5 percent (0.3 times 5 percent) of 900 gallons, makes this particular low-income consumer slightly or 13.5 gallons. The new utility-maximizing con- worse off because H lies just below indifference sumption choice at H reflects this expectation. (We curve U2. of course, some low-income consumers omitted the indifference curve that is tangent at H to might actually benefit from the program (if, for exam- simplify the diagram.) With the rebate program, the ple, they consume less gasoline on average than the tax would reduce gasoline consumption by 286.5 group of consumers whose consumption determines gallons, from 1200 to 913.5. Because the income the selected rebate). Nevertheless, the substitution elasticity of demand for gasoline is relatively low, the effect caused by the tax will make consumers, on income effect of the rebate program is dominated by average, worse off. the substitution effect, and the program with a rebate Why, then, introduce such a program? Those does indeed reduce consumption. who support gasoline taxes argue that they pro- in order to put a real tax-rebate program into mote national security (by reducing dependence effect, Congress would have to solve a variety of on foreign oil) and encourage conservation, thus practical problems. First, incoming tax receipts and helping to slow global warming by reducing the rebate expenditures would vary from year to year, buildup of carbon dioxide in the atmosphere. We making it difficult to plan the budgeting process. For will further examine the impact of a gasoline tax in example, the tax rebate of $450 in the first year of Chapter 9. 4.3 market Demand So far, we have discussed the demand curve for an individual consumer. Now we turn to the market demand curve. Recall from Chapter 2 that a market de- mand curve shows how much of a good consumers overall are willing to buy market demand as its price changes. In this section, we show how market demand curves can curve Curve relating the be derived as the sum of the individual demand curves of all consumers in a quantity of a good that all consumers in a market will buy to particular market. its price. From Individual to market Demand To keep things simple, let’s assume that only three consumers (A, B, and C) are in the market for coffee. Table 4.2 tabulates several points on each con- sumer’s demand curve. The market demand, column (5), is found by adding columns (2), (3), and (4), representing our three consumers, to determine the total quantity demanded at every price. When the price is $3, for exam- ple, the total quantity demanded is 2 + 6 + 10, or 18. Figure 4.10 shows these same three consumers’ demand curves for cof- fee (labeled DA, DB, and DC). In the graph, the market demand curve is the horizontal summation of the demands of each consumer. We sum horizontally to find the total amount that the three consumers will demand at any given  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 145 Table 4.2 dEtErmining thE markEt dEmand curvE (2) (3) (4) (5) (1) IndIvIduaL a IndIvIduaL b IndIvIduaL c MaRket pRIce ($) (unItS) (unItS) (unItS) (unItS) 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 price. For example, when the price is $4, the quantity demanded by the market (11 units) is the sum of the quantity demanded by A (no units), by B (4 units), and by C (7 units). Because all of the individual demand curves slope down- ward, the market demand curve will also slope downward. However, even though each of the individual demand curves is a straight line, the market de- mand curve need not be. In Figure 4.10, for example, the market demand curve is kinked because one consumer makes no purchases at prices that the other con- sumers find acceptable (those above $4). Price 5 (dollars per unit) 4 3 Market Demand 2 1 DA DB DC 0 5 10 15 20 25 30 Quantity FIgure 4.10 summing to obtain a markEt dEmand curvE The market demand curve is obtained by summing our three consumers’ demand curves DA, DB, and DC. At each price, the quantity of coffee demanded by the market is the sum of the quantities demanded by each consumer. At a price of $4, for example, the quantity demanded by the market (11 units) is the sum of the quantity demanded by A (no units), B (4 units), and C (7 units).  146 PART 2 Producers, Consumers, and Competitive markets Two points should be noted as a result of this analysis: 1. The market demand curve will shift to the right as more consumers enter the market. 2. Factors that influence the demands of many consumers will also affect market demand. Suppose, for example, that most consumers in a particu- lar market earn more income and, as a result, increase their demands for coffee. Because each consumer’s demand curve shifts to the right, so will the market demand curve. The aggregation of individual demands into market demands is not just a theoretical exercise. It becomes important in practice when market demands are built up from the demands of different demographic groups or from consumers located in different areas. For example, we might obtain information about the demand for home computers by adding independently obtained information about the demands of the following groups: Households with children Households without children Single individuals Or, we might determine U.S. wheat demand by aggregating domestic demand (i.e., by U.S. consumers) and export demand (i.e., by foreign consumers), as we will see in Example 4.3. elasticity of Demand In §2.4, we show how the Recall from Section 2.4 (page 55) that the price elasticity of demand measures price elasticity of demand the percentage change in the quantity demanded resulting from a 1-percent in- describes the responsive- ness of consumer demands crease in price. Denoting the quantity of a good by Q and its price by P, the price to changes in price. elasticity of demand is ∆Q/Q P ∆Q EP = = a ba b (4.1) ∆P/P Q ∆P (Here, because ∆ means “a change in,” ∆Q/Q is the percentage change in Q.) inElastic dEmand When demand is inelastic (i.e., EP is less than 1 in ab- solute value), the quantity demanded is relatively unresponsive to changes in price. As a result, total expenditure on the product increases when the price increases. Suppose, for example, that a family currently uses 1000 gal- lons of gasoline a year when the price is $1 per gallon; suppose also that our Recall from §2.4 that family’s price elasticity of demand for gasoline is -0.5. If the price of gaso- because the magnitude line increases to $1.10 (a 10-percent increase), the consumption of gasoline of an elasticity refers to its falls to 950 gallons (a 5-percent decrease). Total expenditure on gasoline, absolute value, an elasticity however, will increase from $1000 (1000 gallons * $1 per gallon) to $1045 of -0.5 is less in magnitude than a -1.0 elasticity. (950 gallons * $1.10 per gallon). Elastic dEmand In contrast, when demand is elastic (EP is greater than 1 in absolute value), total expenditure on the product decreases as the price goes up. Suppose that a family buys 100 pounds of chicken per year at a price of $2 per pound; the price elasticity of demand for chicken is -1.5. If the price of chicken increases to $2.20 (a 10-percent increase), our family’s consumption of chicken falls to 85 pounds a year (a 15-percent decrease). Total expenditure  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 147 Price of movie tickets 9 ($) FIgure 4.11 6 unit-Elastic dEmand curvE When the price elasticity of demand is -1.0 at every price, the total expen- 3 diture is constant along the demand curve D. D 600 900 1800 Thousands of movie tickets on chicken will also fall, from $200 (100 pounds * $2 per pound) to $187 (85 pounds * $2.20 per pound). isoElastic dEmand When the price elasticity of demand is constant all along the demand curve, we say that the curve is isoelastic. Figure 4.11 shows isoelastic demand an isoelastic demand curve. Note how this demand curve is bowed inward. In curve Demand curve with a constant price elasticity. contrast, recall from Section 2.4 what happens to the price elasticity of demand as we move along a linear demand curve. Although the slope of the linear curve is constant, the price elasticity of demand is not. It is zero when the price is zero, and it increases in magnitude until it becomes infinite when the price is suffi- ciently high for the quantity demanded to become zero. A special case of the isoelastic curve is the unit-elastic demand curve: a demand In §2.4, we show that when curve with price elasticity always equal to -1, as is the case for the curve in the demand curve is linear, demand becomes more Figure 4.11. In this case, total expenditure remains the same after a price change. elastic as the price of the A price increase, for instance, leads to a decrease in the quantity demanded that product increases. leaves the total expenditure on the good unchanged. Suppose, for example, that the total expenditure on first-run movies in Berkeley, California, is $5.4 million per year, regardless of the price of a movie ticket. For all points along the de- mand curve, the price times the quantity will be $5.4 million. If the price is $6, the quantity will be 900,000 tickets; if the price increases to $9, the quantity will drop to 600,000 tickets, as shown in Figure 4.11. Table 4.3 summarizes the relationship between elasticity and expenditure. It is useful to review this table from the perspective of the seller of the good rather Table 4.3 PricE Elasticity and consumEr ExPEnditurEs IF pRIce IncReaSeS, IF pRIce decReaSeS, deMand expendItuReS expendItuReS Inelastic Increase decrease unit elastic are unchanged are unchanged elastic decrease Increase  148 PART 2 Producers, Consumers, and Competitive markets than the buyer. (What the seller perceives as total revenue, the consumer views as total expenditures.) When demand is inelastic, a price increase leads only to a small decrease in quantity demanded; thus, the seller’s total revenue increases. But when demand is elastic, a price increase leads to a large decline in quantity demanded and total revenue falls. examPle 4.3 thE aggrEgatE dEmand for whEat in Chapter 2 (Example 2.5—page 59), we explained that the demand for U.S. wheat has two components: domestic demand (by U.S. consumers) and export demand (by foreign consumers). Let’s see how the total demand for wheat can be obtained by aggregating the domestic and foreign demands. Domestic demand for wheat is given by the equation QDD = 1430 - 55P where QDD is the number of bushels (in millions) demanded domestically, and P is the price in dollars per bushel. Export demand is given by QDE = 1470 - 70P where QDE is the number of bushels (in millions) demanded from abroad. As shown in Figure 4.12, domestic demand, given by AB, is relatively price in- elastic. (Statistical studies have shown that price elasticity of domestic demand is about -0.2 to -0.3.) However, export demand, given by CD, is more price elastic, with an elasticity of about -0.4. Why? Export demand is more elastic 30 FIgure 4.12 A thE aggrEgatE 25 Total Demand dEmand for C E whEat Price (dollars per bushel) 20 The total world demand for wheat is the horizontal sum of the domestic de- 15 mand AB and the export demand CD. Even though Export Demand each individual demand 10 curve is linear, the market demand curve is kinked, Domestic Demand reflecting the fact that 5 there is no export demand when the price of wheat B D F is greater than about $21 0 per bushel. 0 500 1000 1500 2000 2500 3000 Quantity (million bushels per year)  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 149 than domestic demand because poorer countries that import U.S. wheat turn to other grains and foodstuffs if wheat prices rise.3 To obtain the world demand for wheat, we set the left side of each demand equation equal to the quantity of wheat (the variable on the horizontal axis). We then add the right side of the equations, obtaining QDD + QDE = (1430 - 55P) + (1470 - 70P) = 2900 - 125P This generates the line segment EF in Figure 4.12. At all prices above point C, however, there is no export demand, so that world demand and domestic demand are identical. As a result, for all prices above C, world demand is given by line segment AE. (if we were to add QDE for prices above C, we would be incorrectly adding a negative export demand to a positive domestic demand.) As the figure shows, the resulting total demand for wheat, given by AEF, is kinked. The kink occurs at point E, the price level above which there is no export demand. Speculative Demand So far in our treatment of demand, we have assumed that consumers are “ratio- speculative demand nal,” in that they allocate their income among various goods and services to max- Demand driven not by the direct benefits one obtains from owning imize their overall satisfaction. At times, however, the demands for some goods or consuming a good but instead are based not on the satisfaction one obtains from actually consuming the good, by an expectation that the price of but instead on the belief that the price of the good will rise. In that case, it might the good will increase. be possible to profit by buying the good and then reselling it later at a higher price. This speculative demand is partly to blame for the sharp increases in hous- ing prices that occurred in the U.S., Europe, and China during the past decade. Speculative demand is often (but, as we will explain in Chapter 5, not always) irrational. People see that the price of a good has been rising, and somehow conclude that the price will therefore keep rising. But there is usually no rational basis for the “therefore,” so that a consumer who buys something because he believes the price will keep rising is often doing little more than gambling. examPle 4.4 thE dEmand for housing Housing is typically the most im- decision. one approach to the portant single expenditure in a housing demand is to relate the household’s budget—on average, number of rooms per house for each households spend 25 percent of household (the quantity demanded) their income on housing. A fam- both to an estimate of the price of ily’s demand for housing de- an additional room in a house and pends on the age and status of the to the household’s family income. household making the purchasing (Prices of rooms vary because of 3 For a survey of statistical studies of demand and supply elasticities and an analysis of the U.S. wheat market, see Larry Salathe and Sudchada Langley, “An Empirical Analysis of Alternative Export Subsidy Programs for U.S. Wheat,” Agricultural Economics Research 38, No. 1 (Winter 1986). See also Michael J. Roberts and Wolfram Schlenker, “Identifying Supply and Demand Elasticities of Agricultural Commodities: Implications for the U.S. Ethanol Mandate,” American Economic Review Vol. 103, No. 6 (October 2013): 2265–95.  150 PART 2 Producers, Consumers, and Competitive markets Table 4.4 PricE and incomE ElasticitiEs of thE dEmand for rooms GRoup pRIce eLaStIcIty IncoMe eLaStIcIty Single individuals - 0.10 0.21 Married, head of household age less than 30, 1 child - 0.25 0.06 Married, head age 30–39, 2 or more children - 0.15 0.12 Married, head age 50 or older, 1 child - 0.08 0.19 differences in construction costs, including the price would be spent primarily on items other than hous- of land.) Table 4.4 lists price and income elasticities ing. By comparison, the income elasticity for housing for different demographic groups. among the wealthiest households (the top 10 percent) There are significant differences among subgroups is about 0.54. of the population. For example, families with young This discussion assumes that consumers choose household heads have a price elasticity of -0.25, their expenditures on housing and other goods to max- which is more price elastic than the demands of fami- imize their overall satisfaction, where the benefits of lies with older household heads. Presumably, families housing (and thus the demand for housing) arise from buying houses are more price sensitive when parents the amount of living space, the safety of the neighbor- and their children are younger and there may be plans hood, the quality of schools, etc. in recent years, how- for more children. Among married households, the ever, the demand for housing has been partly driven by income elasticity of demand for rooms also increases speculative demand: People bought homes under the with age, which tells us that older households buy assumption that they can re-sell the homes in the future larger houses than younger households. at a much higher price. Speculative demand—demand For poor families, the fraction of income spent on driven not by the direct benefits one obtains from own- housing is large. For instance, renters with an income ing a home but instead by an expectation that the price in the bottom 20 percent of the income distribution will increase—has caused housing prices in many spend roughly 55 percent of their income on hous- parts of the United States to increase sharply, far more ing, as compared to 2.8 percent of income for house- than could be justified by demographics. holds overall.4 many government programs, such as Speculative demand can lead to a bubble—an subsidies, rent controls, and land-use regulations, increase in price based not on the fundamentals of have been proposed to shape the housing market in demand, but instead on a belief that the price will ways that might ease the housing burden on the poor. keep going up. Eventually, bubbles burst—the price How effective are income subsidies? if the sub- stops rising as new buyers stop coming into the mar- sidy increases the demand for housing substantially, ket, owners of the good become alarmed and start to then we can presume that the subsidy will lead to sell, the price drops, more people sell, and the price improved housing for the poor.5 on the other hand, drops further. As we will see in Chapter 5, bubbles if the extra money were spent on items other than are problematic because they can distort the func- housing, the subsidy will have failed to address tioning of a market and lead to financial dislocations policy concerns related to housing. when they burst. That is what happened to the U.S. The evidence indicates that for poor households housing market, which experienced a housing price (with incomes in the bottom tenth percentile of all bubble that finally burst in 2008, leading to mortgage households), the income elasticity of housing is only defaults and contributing to the financial crisis that about 0.09, which implies that income subsidies hit the U.S. and the global economy in late 2008. 4 This is the starting point of the “affordable” housing debate. For an overview, see John Quigley and Steven Raphael, “Is Housing Unaffordable? Why Isn’t It More Affordable,” Journal of Economic Perspectives 18 (2004): 191–214. 5 Julia L. Hansen, John P. Formby, and W. James Smith, “Estimating the Income Elasticity of Demand for Housing: A Comparison of Traditional and Lorenz-Concentration Curve Methodologies,” Journal of Housing Economics 7 (1998): 328–42.  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 151 examPle 4.5 thE long-run dEmand for gasolinE Among industrialized countries, the cars and buy new ones following United States is unique in that the a price increase. one way to get price of gasoline is relatively low. at the long-run demand curve is The reason is simple: Europe, Japan, by looking at per-capital consump- and other countries have stiff taxes tion of gasoline in different coun- on gasoline, so that gas prices are tries which historically have had typically double or triple that in the very different prices (because they United States, which imposes very imposed different gasoline taxes). low taxes on gasoline. many econo- Figure 4.13 does just that. it plots mists have argued that the United States should sub- the per-capita consumption of gasoline on the vertical stantially increase its tax on gasoline, because doing axis and the price in dollars per gallon for 10 countries so would lower gasoline consumption and thereby on the horizontal axis.6 (Each circle represents the reduce dependence on imported oil and reduce the population of the corresponding country.) greenhouse gas emissions that contribute to global Note that the United States has had by far the lowest warming (in addition to providing much-needed rev- gasoline prices and also the highest per-capita gasoline enue to the government). Politicians have resisted, consumption. Australia is roughly in the middle in however, because they fear that a tax increase would terms of prices, and likewise in terms of consumption. anger voters. most of the European countries, on the other hand, Putting the politics of a gas tax aside, would higher have much higher prices and correspondingly lower gasoline prices indeed reduce gasoline consumption, per capita consumption levels. The long-run elasticity or are drivers so wedded to big gas-guzzling cars that of demand for gasoline turns out to be about -1.4. higher prices would make little difference? What mat- Now we come back to our question: Would ters here is the long-run demand for gasoline, because higher gasoline prices reduce gasoline consumption? we can’t expect drivers to immediately scrap their old Figure 4.13 provides a clear answer: most definitely. 500 Gas/Diesel for Transportation (gallons/year/capita) United States FIgure 4.13 400 gasolinE PricEs and PEr caPita consumPtion in 300 10 countriEs New Zealand Australia The graph plots per capita consumption of gasoline ver- sus the price per gallon (con- Sweden verted to U.S. dollars) for 10 200 United Kingdom countries over the period 2008 Germany to 2010. Each circle represents the population of the corre- Austria sponding country. 100 France Norway 2 4 6 8 Gasoline Price 6 Our thanks to Chris Knittel for providing us with the data for this figure. The figure controls for in- come differences and is based on Figure 1 in Christopher Knittel, “Reducing Petroleum Consumption from Transportation,” Journal of Economic Perspectives, 2012. All underlying data are available from www.worldbank.org.  152 PART 2 Producers, Consumers, and Competitive markets 4.4 Consumer Surplus consumer surplus Difference Consumers buy goods because the purchase makes them better off. Consumer between what a consumer is surplus measures how much better off individuals are, in the aggregate, because willing to pay for a good and the amount actually paid. they can buy goods in the market. Because different consumers place different values on the consumption of particular goods, the maximum amount they are willing to pay for those goods also differs. Individual consumer surplus is the dif- ference between the maximum amount that a consumer is willing to pay for a good and the amount that the consumer actually pays. Suppose, for example, that a student would have been willing to pay $13 for a rock concert ticket even though she only had to pay $12. The $1 difference is her consumer surplus.7 When we add the consumer surpluses of all consumers who buy a good, we obtain a measure of the aggregate consumer surplus. Consumer Surplus and Demand Consumer surplus can be calculated easily if we know the demand curve. To see the relationship between demand and consumer surplus, let’s examine the individual demand curve for concert tickets shown in Figure 4.14. (Although the following discussion applies to this particular individual demand curve, a similar argument also applies to a market demand curve.) Drawing the demand curve as a staircase rather than a straight line shows us how to measure the value that our consumer obtains from buying different numbers of tickets. When deciding how many tickets to buy, our student might reason as fol- lows: The first ticket costs $14 but is worth $20. This $20 valuation is obtained Price (dollars per 20 ticket) 19 FIgure 4.14 18 consumEr surPlus 17 Consumer surplus is the total bene- fit from the consumption of a prod- 16 uct, less the total cost of purchasing it. Here, the consumer surplus asso- Consumer Surplus 15 ciated with six concert tickets (pur- chased at $14 per ticket) is given by 14 the yellow-shaded area. 13 0 1 2 3 4 5 6 Rock concert tickets 7 Measuring consumer surplus in dollars involves an implicit assumption about the shape of con- sumers’ indifference curves: namely, that the marginal utility associated with increases in a con- sumer’s income remains constant within the range of income in question. In many cases, this is a reasonable assumption. It may be suspect, however, when large changes in income are involved.  CHAPTER 4 iNDiViDUAL AND mARkET DEmAND 153 by using the demand curve to find the maximum amount that she will pay for each additional ticket ($20 being the maximum that she will pay for the first ticket). The first ticket is worth purchasing because it generates $6 of surplus value above and beyond its cost. The second ticket is also worth buying because it generates a surplus of $5 ($19 - $14). The third ticket generates a surplus of $4. The fourth, however, generates a surplus of only $3, the fifth a surplus of $2, and the sixth a surplus of just $1. Our student is indifferent about purchas- ing the seventh ticket (which generates zero surplus) and prefers not to buy any more than that because the value of each additional ticket is less than its cost. In Figure 4.14, consumer surplus is found by adding the excess values or surpluses for all units purchased. In this case, then, consumer surplus equals $6 + $5 + $4 + $3 + $2 + $1 = $21 To calculate the aggregate consumer surplus in a market, we simply find the area below the market demand curve and above the price line. For our rock con- cert example, this principle is illustrated in Figure 4.15. Now, because the num- ber of tickets sold is measured in thousands and individuals’ demand curves differ, the market demand curve appears as a straight line. Note that the actual expenditure on tickets is 6500 * $14 = $91,000. Consumer surplus, shown as the yellow-shaded triangle, is 1/2 * ($20 - $14) * 6500 = $19,500 This amount is the total benefit to consumers, less what they paid for the tickets. Of course, market demand curves are not always straight lines. Nonetheless, we can always measure consumer surplus by finding the area below the de- mand curve and above the price line. 20 Price (dollars per 19 ticket)