2. Consumer´s demand analysis Structure ØFactors influencing an individual demand ØThe impact of disposable income change: -income consumption curve, Engel curves -income elasticity of demand ØThe impact of the change of price of selected goods on the quantity demanded: -price consumption curve and demand derivation -substitution and income effect, Giffen paradox, price elasticity of demand ØThe impact of the change of price of other goods on the quantity demanded: — - cross substitution effect, cross income effect — - cross elasticity of demand ØRelationship between demand elasticities, substitution elasticity ØDerivation of market demand Characteristics of an individual demand — Individual demand = demand of the sole consumer... — ...depends on: Ødisposable income Øprice of the selected goods Øprice of other goods Øconsumer´s preferences and expectations The impact of the change of disposable income on the individual demand Øall other factors remain the same Øthe change of disposable income moves the budget line... and the consumer´s equilibrium... Ø...↑I → BL (+consumer´s equi.) moves rightwards, ↓I → BL (+consumer´s equi.) moves leftwards ØICC (Income Consumption Curve) = set of the consumer´s equilibria upon different levels of disposable income (or: IEP – Income Epansion Path) Ø Income consumption curve – standard path X Y E1 E2 E3 ICC Growing income induces the growth of consumption of all „normal“ goods I1 I2 I3 IC1 IC2 IC3 What is „normal“ goods? Ø...if the growth of disposable income induces the growth of consumption of specific goods, we can say it is a „normal goods“, and... Ø...if the decrease of disposable income induces the decrease of consumption of specific goods, so... Ø...↑I → ↑Q or ↓I → ↓Q Øessential goods – a subset of normal goods = if the growth/decrease of disposable income is relatively higher than the growth/decrease of the consumption: ↑I > ↑Q or ↓I > ↓Q Øluxury goods – a subset of normal goods = if the growth/decrease of disposable income is relatively smaller than the growth/decrease of the consumption: ↑I < ↑Q or ↓I < ↓Q Øthe opposite of normal goods = inferior goods – the growth of disposable income induces the decrease of the consumption, and vice versa: ↑I → ↓ Q or ↓I → ↑ Q Øit depends on consumer´s preferences which goods is normal, or inferior Application: EKC – Environmental Kuznets Curve Øshows the relation between GDP per capita and the level of erosion of the environment Øshape of inverse „U“ Øexplanation: environment is a luxury good – when the GDP/cap. is relatively low, people prefer everything but the clean environment, but when the GDP/cap. reaches a critical level, the demand for clean environment rises faster than the GDP/cap. does Application: EKC – Environmental Kuznets Curve GDP/cap. level of environment erosion EKC Income consumption curve – essential and luxury goods X Y E1 E2 ICC X is essential – its consumption grows slower than the disposable income X Y E1 E2 ICC X is luxury – its consumption grows faster the disposable income Income consumption curve – inferior goods X Y E1 E2 ICC X is inferior – consumption decreases while disposable income rises Engel Curve - EC Øshows the relation between the volume of goods consumption and the disposable income Engel curve - derivation X E1 E2 E3 ICC Y I3 I2 I1 X3 X2 X1 X1 X2 X3 I1 I2 I3 I X EC Engel curve for essential, luxury and inferior goods I X I X I X EC EC EC X is essential – its consumption grows slower than the disposable income X is luxury – its consumption grows faster the disposable income X is inferior – consumption decreases while disposable income rises Engel Expenditure Curve - EEC Ørepresents the relation between the disposable income and total consumer´s expenditures on specific goods... Ø... the relation between P.Q and I Engel expenditure curve for essential, luxury and inferior goods I PX.X I I EEC EEC EEC PX.X PX.X 45° 45° 45° X is essential – expenditures on X grow slower than the disposable income X is luxury – expenditures on X grow faster the disposable income X is inferior – expenditures on X decrease while disposable income rises Income elasticity of demand Ø...reflects the sensitivity of consumer´s reaction to the change of disposable income and his/her consumption Øit is a relative change of quantity demanded induced with the change of disposable income Income elasticity of demand ØeID = (ΔX/X)/(ΔI/I) or eID = (∂X/∂I/X/I) ØeID> 0 for normal goods, eID < 0 for inferior goods ØeID > 1 for luxury goods, 0 < eID < 1 for essential goods Øsum of income elasticities of all consumed goods multiplied with the ratio of each good in the commodity cage must equal to 1 → μX.eIDX + μY.eIDY = 1, where: ØμX... ratio of X, μY...ratio of Y Ø→ if we buy a luxury good, we cannot avoid buying an inferior good either The impact of the change of price of specific goods on the quantity demanded Øwe suppose the change of price of X, while everything else remains unchanged (price of Y and disposable income) Øif the price of X changes, the BL changes its slope (BL rotates clock-wise, or anticlock-wise) ØPCC (Price Consumption Curve) Price consumption curve —PCC = set of consumer´s equilibria upon different prices of specific good E1 E2 E3 PCC X Y PCC and the derivation of individual demand curve PCC X Y X1 X3 X2 X1 X2 X3 P1 P2 P3 P1 P2 P3 X dX Substitution and income effect – Hicks approach ØSubstitution Effect (SE) = change of quantity demanded resulting from the substitution of relatively more expensive good with the relatively cheaper good – SE is always negative, which means: ↓P → ↑X and vice versa, consumer moves along the original IC ØIncome Effect (IE) = change of quantity demanded resulting from the change of real disposable income – IE is negative for normal goods (↓P → ↑X and vice versa), and positive for inferior goods (↓P→↓X and vice versa), consumer moves to another IC ØNote: IE increases the consumption of normal goods and decreases the consumption of inferior goods (in case of growing real income) ØTotal Effect (TE) = sum of SE + IE Hicks decomposition on SE and IE – X is normal good X Y U1 U2 SE IE A TE B C Shift from A to B – substitution effect, the level of total utility remains constant Shift from B to C – income effect, shift to higher IC (higher level of total utility) Shift from A to C – total effect, sum of SE and IE Hicks decomposition on SE and IE – X is inferior good X Y U1 U2 SE IE A TE B C Income effect counterworks the substitution effect – total effect still induces the growth of X consumption but not as much as in the case of normal good Giffen good (Giffen paradox) Øit is a subset of inferior goods Øthe decrease of price induces the decrease of quantity demanded and vice versa → individual demand curve has a positive slope Øgoods with relatively high ratio on total consumer´s expenditures; fulfils basic needs; there are no close substitutes Øan important role of consumer´s expectations Øi.e. basic food, fuel etc. during a crisis Hicks decomposition on SE and IE – X is Giffen good X Y U1 U2 SE IE A TE B C Income effect counterworks the substitution effect, and IE>SE – total effect implies that if the price of X decreases, the quantity of X demanded is decreasing Slutsky approach to the SE and IE Ødifferent approach to the substitution effect resulting from the change of price of goods ØHicks SE – consumer is able to reach the constant level of total utility after the relative prices change ØSlutsky SE – consumer is able to reach the former commodity cage after the change of relative prices ØSlutsky´s SE includes some of the Hicks´s IE Ø Slutsky decomposition on SE and IE – X is a normal good X U1 U2 SE IE A TE B C Y Shift from A to B – substitution effect, shift to the higher level of TU (broken lined IC) Shift from B to C – income effect, shitf to the higher (final) level of TU (IC marked U2) Shift from A to C – total effect, a sum of SE and IE Intersection of A and subsidiary BL (broken lined BL): consumer is able to reach the former commodity cage but for the new relative prices Price elasticity of demand Øreflects the sensitivity of consumer´s reaction to the change of relative price of good and his/her quantity demanded ØePD=(ΔX/X)/(ΔPX /PX) or ePD=(∂X/∂PX/X/PX) Øif ePD= -1, then demand is unitarily elastic – relative change of quantity demanded is the same as the relative change of price ØePD> -1, then demand is inelastic – relative change of quantity demanded is lower than the relative change of price ØePD< -1, then demand is elastic – relative change of quantity demanded is higher than the relative change of price ØePD> 0, then we talk about the Giffen paradox (Giffen good) – quantity demanded increases with increasing price and vice versa ØNote: slope vs. price elasticity of demand The impact of the change of price of specific goods on the other goods quantity demanded Øhow the change of price of good X influences the quantity demanded of good Y, so: Øhow the consumer reflects the change of price of substitutes or complements ØCross SE – induces the substitution of relatively more expensive good with relatively cheaper good – is positive: ↑PY → ↑X and vice versa ØCross IE – induces the change of quantity demanded resulting from the change of real disposable income – is negative: ↑PY → ↓X ØCross TE – a sum of cross SE and cross IE – the direction depends on the relationship between the goods (substitutes or complements?) Decomposition on cross SE and IE - complements X Y U1 U2 SE IE A B C TE Shift from A to B – cross SE Shift from B to C – cross IE Shift from A to C – cross TE, a sum of cross SE and IE In the case of complements the cross IE outweighs the cross SE – i.e. if the diesel gets cheaper (good Y), the demand for cars with diesel engines (good X) increases X U1 U2 SE IE A B C TE Y In the case of substitutes the cross SE outweighs the cross IE – if coffee gets cheaper (good Y), the demand for black tea (good X) declines Decomposition on cross SE and IE - substitutes Shift from A to B – cross SE Shif from B to C – cross IE Shift from A to C – cross TE, a sum of cross SE and IE Task: —What are the cross effects in the case of perfect complements and/or perfect substitutes? Cross elasticity of demand Øreflects the relative change of quantity demand of specific good (godd X) reulsting from the relative change of price of the other good (good Y) ØeCD=(ΔX/X)/(ΔPY /PY) or eCD=(∂X/∂PY/X/PY) Øif eCD > 0, then X and Y are substitutes Øif eCD < 0, then X and Y are complements Øfor the sum of all three kinds of elasticities stands: — eID + ePD + eCD = 0 ... why? Ø Elasticity of substitution Øreflects the relative change of the ratio of substitution of goods with each other... Ø...a variable that implies the shape of indifference curves Øσ = Δ(Y/X) : Δ(MRSC) — Y/X MRSC Øσ = ∞ for perfect substitutes Øσ = 0 for perfect complements Derivation of market demand Ømarket demand is the horizontal sum of all individual demands (demands of all consumers) for the specific good Derivation of market demand 4 8 6 3 Q P 15 Individual demands of „green“ and „red“ consumer P 6 3 8 23 Market demand = demand of „green“ consumer + demand of „red“ consumer DT DR DG