Çhapter 5

Individual and Market Demand

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
Introduction (1/2) 5

Chapter Outline
5.1 How Income Changes Affect an Individual’s Consumption Choices
5.2 How Price Changes Affect Consumption Choices
5.3 Consumer Responses to Price Changes: Substitution and Income

Copyright © 2020 by Macmillan Learning. All Rights Reserved

Effects
5.4 The Impact of Changes in Another Good’s Price: Substitutes and
Complements
5.5 Combining Individual Demand Curves to Obtain the Market Demand
Curve
5.6 Conclusion

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

 Introduction (2/2) 5
With the consumer choice framework in place, we now link
consumer decisions with individual and market demand.

These links help determine:

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• why shifts in tastes affect prices.
• the benefits products offer consumers.
• what happens to purchase patterns as consumers (or even entire
countries) become wealthier.
• how changes in the price of one good affect the demand for other
goods.
• what factors determine consumers’ responses to price changes.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (1/12)
5.1
The income effect is the change in a consumer’s consumption
choices that results from a change in the consumer’s income (or
purchasing power), holding relative prices constant.

Is higher income associated with higher consumption of goods?

Copyright © 2020 by Macmillan Learning. All Rights Reserved

It depends!

For normal goods, higher income is associated with rising

consumption.
• For instance, consider vacations and basketball tickets, both of which
are considered normal goods.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (2/12)
5.1
Figure 5.1 A Consumer's Response to an Increase in
Income When Both Goods Are Normal

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
How Income Changes Affect an Individual’s
Consumption Choices (3/12)
5.1
Alternatively, for inferior goods, higher income is associated with falling
consumption.

Figure 5.2 Consumer's Response to an Increase in Income When One Good is Inferior

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
How Income Changes Affect an Individual’s
Consumption Choices (4/12)
5.1
Income Elasticities and Types of Goods
Chapter 2 introduced the concept of elasticity.
• Income elasticity describes the response of demand to changing income.
‒ Specifically, the percentage change in quantity consumed associated
with a percentage change in income

Copyright © 2020 by Macmillan Learning. All Rights Reserved

%Q Q / Q Q I
Mathematically, E 
D
I  
%I I / I I Q
where I is income and Q is the quantity of a good demanded.

Q
The income effect is given by
I
MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
How Income Changes Affect an Individual’s
Consumption Choices (5/12)
5.1
Income Elasticities and Types of Goods
Thus, the sign of the income elasticity is the same as the income effect.
Q
If E  0   0 , the good in question is a normal good.
D
I
I

Copyright © 2020 by Macmillan Learning. All Rights Reserved

Q
If E  0   0 , the good in question is an inferior good.
D
I
I

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (6/12)
5.1
There are two additional sub-types of goods that are common, both of
these are classified as normal goods because, as income increases,
the quantity demanded for them increases as well, and vice versa.

• Necessity goods: normal goods for which income elasticity is between 0

and 1

Copyright © 2020 by Macmillan Learning. All Rights Reserved

‒ Examples: water consumption, electricity, clothing, etc…

• Luxury goods: normal goods for which income elasticity is greater than 1
‒ Examples: vacation homes, jewelry, expensive steaks, etc…

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (7/12): Question 1
5.1
If the consumption of fresh cut flowers increases by 10% when
consumers’ incomes increase by 5%, fresh cut flowers are:

A. inferior goods.
B. necessity goods.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

C. luxury goods.
D. ordinary goods.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (7/12): Question 1 – Correct
Answer
5.1
If the consumption of fresh cut flowers increases by 10% when
consumers’ incomes increase by 5%, fresh cut flowers are:

A. inferior goods.
B. necessity goods.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

C. luxury goods. (correct answer)
D. ordinary goods.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

 How Income Changes Affect an Individual’s
Consumption Choices (8/12)
5.1
Income expansion path: a curve that connects a consumer’s
optimal bundles at each income level

• Only two goods can be represented.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• When both goods are normal goods, the path is positively sloped.

• If the slope of the income path is negative, one of the goods is an

inferior good.

• Income levels can’t be directly observed on the curve because both

axes represent quantities of goods.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (9/12)
5.1
Figure 5.3 The Income Expansion Path

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
 How Income Changes Affect an Individual’s
Consumption Choices (10/12)
5.1
A more common way to describe the consumption-income
relationship is with an Engel curve.

• Shows the relationship between quantity of a good consumed and a

consumer’s income

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• If the Engel curve has a positive slope, the good is a normal good at
that income level.

• If the Engel curve has a negative slope, the good is an inferior good
at that income level.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (11/12)
5.1
Figure 5.4 An Engel Curve Shows How Consumption Varies
with Income

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
How Income Changes Affect an Individual’s
Consumption Choices (12/12): Question 2
5.1
Susan’s income elasticity for canned meat is negative at each of
her income levels and is positive for organic fruit. This implies that
Susan’s income expansion path along her optimal canned meat
and organic fruit bundles will have a ____________ slope, and the
Engel curve for canned meat will have a __________ slope.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

A. positive; positive
B. positive; negative
C. negative; positive
D. negative; negative

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Income Changes Affect an Individual’s
Consumption Choices (12/12):
Question 2 – Correct Answer
5.1
Susan’s income elasticity for canned meat is negative at each of
her income levels and is positive for organic fruit. This implies that
Susan’s income expansion path along her optimal canned meat
and organic fruit bundles will have a ____________ slope, and the
Engel curve for canned meat will have a __________ slope.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

A. positive; positive
B. positive; negative
C. negative; positive
D. negative; negative (correct answer)

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Price Changes Affect
Consumption Choices (1/4)
5.2
Just as income affects consumer choices, changes in relative prices—
holding income constant—also affects these choices.

Deriving a Demand Curve

• Demand curves define a relationship between quantity demanded
and price.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• To derive a demand curve, we must understand how a consumer
responds to a change in price.
• By changing one price on an indifference curve—budget constraint
map, we can observe changes to consumer choices and then build
the demand curve for an individual using these observed changes.
• The observed price represents the maximum willingness to pay for
the last unit consumed.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Price Changes Affect
Consumption Choices (2/4)
5.2
Figure 5.5 Building an Individual's Demand Curve

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
How Price Changes Affect
Consumption Choices (3/4)
5.2
Shifts in the Demand Curve
When consumer preferences, income, or the prices of other goods
change, the demand curve will shift.

Consider the example of Mountain Dew and grape juice from the
previous figure.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• Imagine the consumer (Caroline) prefers the taste of Mountain Dew, but had
previously limited consumption due to worries about high fructose corn syrup.
• After hearing advertisements from the Corn Refiners Association claiming
corn syrup is identical to cane sugar, her fears are reduced.

What might happen to the demand for grape juice?

‒ In order to consume more Mountain Dew, she might reduce her consumption of
grape juice.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

How Price Changes Affect
Consumption Choices (4/4)
5.2
Figure 5.6 Preference Changes and Shifts in the Demand
Curve
(a) Caroline’s indifference curves for
grape juice flatten when her
preference for grape juice decreases
relative to her preference for
Mountain Dew. At each price level,
she now consumes fewer bottles of
grape juice.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

(b) Because she purchases fewer
bottles of grape juice at each price
point, Caroline’s demand curve for
grape juice shifts inward from D1 to
D2.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

 Consumer Responses to Price Changes:
Substitution and Income Effects (1/16) 5.3
When the price of a good changes relative to another, two things
happen:
1. One good becomes relatively more expensive, and the other relatively less.
2. The total purchasing power of a consumer’s income changes.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

The substitution effect refers to the change in a consumer’s
consumption choices that results from a change in the relative prices of
two goods.

Always negative; when the price of one good relative to another

increases, consumption of the former falls, and vice versa.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (2/16) 5.3
The income effect refers to the change in a consumer’s consumption
choices that results from a change in the purchasing power of the
consumer’s income.
• This is the same income effect from Section 5.1.
• Can be negative or positive (inferior or normal goods)

Copyright © 2020 by Macmillan Learning. All Rights Reserved

The total effect of a change in a price is the sum of the substitution and
income effects.
• The total effect is simply the observed change in consumption of a
good after a price change.

Total Effect = Substitution Effect + Income Effect

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (3/16) 5.3
Figure 5.7 The Effects of a Fall in the Price of Basketball
Tickets

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
Consumer Responses to Price Changes:
Substitution and Income Effects (4/16) 5.3
Total Effect = Substitution Effect + Income Effect

Isolating the Substitution Effect

• Determine the bundle of goods that would have been chosen
at the new price while maintaining utility experienced before

Copyright © 2020 by Macmillan Learning. All Rights Reserved

the price change.

Isolating the Income Effect

• The change in quantities demanded due to the changes in the
consumer’s purchasing power after the change in prices

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (5/16) 5.3
Graphically
Substitution Effect:
‒ To do this for a fall in the price of basketball tickets, shift the new
budget constraint (BC2) inward until it is tangent with the old
indifference curve (BC′).
‒ Movement along the original indifference curve (A to A′)

Copyright © 2020 by Macmillan Learning. All Rights Reserved

Income Effect:
When the price of basketball tickets decreases, the consumer can
afford to purchase a larger bundle than before.
‒ Represented by the change in the quantity of goods consumed
from bundle A’ (after the substitution effect) to bundle B

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (6/16) 5.3
Figure 5.8 Substitution Effects and Income Effects for Two
Normal Goods

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
 Consumer Responses to Price Changes:
Substitution and Income Effects (7/16) 5.3
Three steps to computing substitution and income effects associated
with a price change, starting with a consumer at an optimal bundle A:

1. Draw the new budget constraint and find the new optimal bundle ( B ).
‒ A price change for one of two goods rotates or pivots the constraint.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

2. Draw a line parallel to the new budget constraint, but tangent to the
old indifference curve; determine the optimal bundle on the old curve
associated with this theoretical budget constraint ( A′ ).

3. The substitution effect is the difference in quantities between A and

A′ and the income effect is the difference in quantities between A′
and B.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

 Consumer Responses to Price Changes:
Substitution and Income Effects (8/16) 5.3
What Determines the Size of the Substitution and Income Effects?
1. Curvature: The size of the substitution effect depends on the
curvature of indifference curves.

What does it mean when an indifference curve is relatively straight?

‒ The 2 goods are relatively substitutable.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

Is the substitution effect larger or smaller along a straighter indifference curve?
‒ Larger, more substitutable = Larger substitution effect

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

 Consumer Responses to Price Changes:
Substitution and Income Effects (9/16) 5.3
2. Quantity consumed before the price change: The income effect
increases with the amount spent on a good before a price change.

Why does the income effect increase with the amount spent on a good?
The more you can get from trading off consumption of that good

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
 Consumer Responses to Price Changes:
Substitution and Income Effects (10/16) 5.3
Example of the Substitution and Income Effects for an Inferior Good
It is important to see how the income and substitution effects are opposed
to one another with an inferior good.

Consider a consumer choosing bundles of steak and ramen noodles.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• Suppose the price of ramen noodles (an inferior good) falls.
• Total effect followed by Income and Substitution effects graphically

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (11/16) 5.3
Figure 5.10 A Fall in the Price of an Inferior Good

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
 Consumer Responses to Price Changes:
Substitution and Income Effects (12/16) 5.3
Figure 5.11 Substitution and Income Effects for an Inferior Good
Changes:
1. Price of ramen noodles has
decreased
‒ Sub. Effect positive

2. Relative price of steak has

increased

Copyright © 2020 by Macmillan Learning. All Rights Reserved

‒ Sub. Effect negative

3. Relative income has increased

‒ Income effect positive for
steak (normal good) and
negative for ramen (inferior
good)

The income effect dominates the

substitution effect for steak.

The substitution effect dominates

the income effect for ramen noodles.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (13/16) 5.3
Giffen goods: goods for which a fall in price leads the consumer
to want less of the good
• Inferior goods, but the income effect outweighs the substitution effect
• When the price of a Giffen good drops, the substitution effect (which
acts to increase demand) is smaller than the income effect
‒ Results in an upward sloping demand curve!

Copyright © 2020 by Macmillan Learning. All Rights Reserved

Economists sometimes question whether Giffen goods actually
exist
• The few examples with humans tend to focus on very poor
households and commodity crops (e.g., rice and potatoes)

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (14/16) 5.3
Figure 5.12 A Change in the Price of a Giffen Good

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
 Consumer Responses to Price Changes:
Substitution and Income Effects (15/16) 5.3
Simple Rules About Income and Substitution Effects

Substitution Effects Income Effects

• Involve comparisons of bundles that line on • Involve comparisons of bundles that lie on two
the same indifference curve. different indifference curves.
• The direction of the effect on quantity • The direction of the effect on quantity consumed for a
consumed for a given change in the relative given change in the relative price of the good is
price of the good is unambiguous. ambiguous and depends on whether the good is

Copyright © 2020 by Macmillan Learning. All Rights Reserved

• If the good’s relative price falls, the normal or inferior.
substitution effect causes the consumer to • If the good is normal, then a fall in either its price or
want more of it. the price of the other good will cause the consumer
• If the good’s relative price rises, the to want more of it. (A drop in any price, even of
substitution effect causes the consumer to another good, increases the effective income of the
want less of it. consumer.) If the good is inferior, then a price drop
will cause the consumer to want less of it.
• If the good is normal, then a rise in it’s price or the
price of the other good will cause the consumer to
want less of it. If the good is inferior, then a rise in
either price will cause the consumer to want more of
it.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (16/16):
Question 1
5.3
At his current income level, Randall’s income elasticity for frozen
dinners is -0.75. If the price of frozen dinners decreases by 10%,
the substitution effect will cause Randall to _________ his
consumption of frozen dinners, and the income effect will cause
Randall to ________ his consumption of frozen dinners.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

A. increase; increase
B. increase; decrease
C. decrease; increase
D. decrease; decrease

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Consumer Responses to Price Changes:
Substitution and Income Effects (16/16):
Question 1 – Correct Answer
5.3
At his current income level, Randall’s income elasticity for frozen
dinners is -0.75. If the price of frozen dinners decreases by 10%,
the substitution effect will cause Randall to _________ his
consumption of frozen dinners, and the income effect will cause
Randall to ________ his consumption of frozen dinners.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

A. increase; increase
B. increase; decrease (correct answer)
C. decrease; increase
D. decrease; decrease

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

The Impact of Changes in Another Good’s
Price: Substitutes and Complements (1/6)
5.4
A Change in the Price of a Substitute Good
When the price of a substitute good increases, we expect
consumption of the primary good to increase.
• Consider Pepsi and Coke

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
The Impact of Changes in Another Good’s
Price: Substitutes and Complements (2/6)
5.4
Figure 5.13 When the Price of a Substitute Rises, Demand
Rises

At original prices, this consumer purchases 15

bottles of Pepsi and 5 bottles of Coke.
When the price of Pepsi doubles, Coke

Copyright © 2020 by Macmillan Learning. All Rights Reserved

consumption increases by 100% (to 10 bottles),
and Pepsi consumption falls by 67% (to 5 bottles).
Coke consumption rose when the price of Pepsi
rose, signifying that they are substitutes.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

The Impact of Changes in Another Good’s
Price: Substitutes and Complements (3/6)
5.4
A Change in the Price of a Complementary Good
When the price of a complement increases, we expect
consumption of the primary good to decrease.
• Consider ice cream and hot fudge

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
The Impact of Changes in Another Good’s
Price: Substitutes and Complements (4/6)
5.4
Figure 5.14 When the Price of a Complement
Rises, Demand Decreases
At original prices, this consumer
purchases 20 tubs of ice cream and
30 jars of hot fudge.
When the price of ice cream

Copyright © 2020 by Macmillan Learning. All Rights Reserved

doubles, consumption of ice cream
falls by 25% (20 to 15 tubs), and
consumption of hot fudge
decreases by 33% (30 to 20 jars).

Hot fudge consumption decreased

when the price of ice cream
increased, signifying that they are
complements.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

The Impact of Changes in Another Good’s
Price: Substitutes and Complements (5/6)
5.4
A Change in the Price of Substitutes and Complements
When the price of a substitute good increases, we expect consumption of
the primary good to increase.
• Recall the Pepsi and Coke example

Copyright © 2020 by Macmillan Learning. All Rights Reserved

When the price of a complement increases, we expect consumption of the
primary good to decrease.
• Recall the ice cream and hot fudge example

These relationships help to explain the shifts in demand examined in

Chapter 2.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

The Impact of Changes in Another Good’s
Price: Substitutes and Complements (6/6)
5.4
Figure 5.15 Changes in the Prices of Substitutes or
Complements Shift the Demand Curve

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
Combining Individual Demand Curves to Obtain
the Market Demand Curve (1/3)
5.5
The final step linking consumer theory to market demand:
• Market demand is the horizontal sum of individual demand curves.
• The market quantity demanded at each price is the sum of the
individual quantities demanded at each price.

The market demand curve is found by summing horizontally the

Copyright © 2020 by Macmillan Learning. All Rights Reserved

individual demand curves.

Consider the market for wireless speakers.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Combining Individual Demand Curves to Obtain
the Market Demand Curve (2/3)
5.5
Figure 5.17 The Market Demand Curve

Copyright © 2020 by Macmillan Learning. All Rights Reserved

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition
Combining Individual Demand Curves to Obtain
the Market Demand Curve (3/3)
5.5
Mathematically connecting the individual and market demand,
Qmarket = Qyou + Qcousin = (5−0.5P) + (13−0.25P)

Qmarket = 18−0.3P

Copyright © 2020 by Macmillan Learning. All Rights Reserved

The difference in choke prices implies your demand function is the market
demand function for prices between $52 (cousin’s choke price) and $100
(your choke price).
• The market demand function applies to prices less than $52.
Qmarket = 18−0.3P for P < $52
Qmarket = 5−0.5P for P ≥ $52

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition

Conclusion (1/1) 5.6
This chapter concludes our in-depth analysis of the
consumer side of the supply and demand model. We:
• examined how income and prices affect consumer choices.
• made the link between consumer theory and market demand.

Copyright © 2020 by Macmillan Learning. All Rights Reserved

In Chapter 6, we begin a parallel in-depth examination of
producer behavior.

MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition