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Unit 1.3

Individual and Market demand

F&D: Chapter 4
Additional Notes
Workbook: Unit 1.3

Outcomes
 Define, explain and illustrate:
◦ the price-consumption curve (PPC)
◦ the effect of (a) a change in price and (b) a change in income on the consumer’s
equilibrium for both a normal and inferior product by making use of the income and
substitute effect.
◦ the income-consumption curve (ICC)
 How the income and substitution effect can be used to explain consumer’s
reaction on price sensitive and non-price sensitive products.
 Engel-curves for different products – luxury, inferior and necessities.
 Explain and illustrate the difference between the income and substitution
effect by using indifference curves – for both normal and inferior goods.
 Calculate and interpret the price elasticity of demand, income elasticity of
demand as well as the total expenditure/income by making use of the
necessary line-functions
 The effect of a positive- and negative network externality – “bandwagon
effect’, snob-effect, pure price effect and total effect.

1. The Effect of Changes in Price

 Price-consumption curve (PCC): set of

optimal bundles for 2 goods as the price of
X varies, holding income and the price of Y
constant.

 Purpose: used to derive demand curve

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Figure 4.1:The Price-Consumption

Curve: P housing↓, Income stays R2400
2400/
1
2400

2400/
80

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2.5
2400/ 2400/ 2400/
480 240 120 4

Figure 4.2: An Individual Consumer’s

Demand Curve correct
Price (R/sq m)
As the price of housing
480 (2.5: 480) decreases
(480…..240….120….80),
more and more housing
are demanded
(2.5….7….15….20)

(7: 240)
240

120
80

Shelter (sq m/wk)

0
2.5 7 5

2. Effects of Changes in Income

 Income-consumption curve (ICC): shows the
set of optimal bundles for 2 goods, as the income
varies, holding the prices of X and Y constant.

 Engel
curve: curve that plots the relationship
between the optimal quantity of X consumed and
income.
- Normal product: Qd rises as income rises.
- Inferior product: Qd falls as income rises

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Figure 4.3: An Income-Consumption

Curve
P stays R200, Income ↑
The composite good (R/wk)

2 400

2 000

1600
1200/
1 1200
1000
800
600
800/ 400
1
Shelter (sq m/wk)
2 3

800/ 1200/ 7
200 200

Figure 4.4: An Individual Consumer’s

Engel Curve

Income (R/wk)

2 400
Qd increases (2…3…4…4.5)
2 000 as the income increases
(800…1200…2000…2400)
800 POSITIVE relationship for
normal goods
1200 (3: 1200)

800 (2: 800)

400

Shelter(sq m/wk)
2 3
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Figure 4.36 p 125: Engel Curves for

Different Types of Goods

Average Income (R/wk) Average Income (R/wk)

0 0

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3. Engel curves

 Difference between products:

◦ Normal products
 Luxury products – positive slope + elastic
(flatter): %Q > %Y
 Necessities – positive slope + inelastic
(steeper): %Y > %Q

◦ Inferior products – negative slope

Figure 4.36 p 125: Engel Curves for

Different Types of Goods

Average Income (R/wk) Average Income (R/wk)

0 0

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Engle curves practice in class

You are given the following income

elasticities of demand (Ey).
◦Steak: Ey = 3.12
◦Water: Ey = 0.53
◦2nd hand clothing: Ey = -1.43
Classify these products and draw
the Engel curve of each of the
products.

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4. Income and Substitution Effects

 Substitution effect: that component of the total
effect of a price change that results from the
associated change in the relative attractiveness of
other goods.

 Income effect: that component of the total effect

of a price change that results from the associated
change in real purchasing power.

 Total effect: the sum of the substitution and

income effect.
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Figure 4.6:The Total Effect

of a Price Increases, budget line

Y (R/wk)
You need to draw point D
higher than point A (e.g 1400
>1200…with a large gap
2400
between A & D
TE: 10-2 = 8

1440
1200

Shelter (sq m/wk)

2400/
120
2400/
480 14

Figure 4.7:The Substitution and Income Effects of a Price

Change/increases for a Normal Good

Move the second budget line

parallel to the right to tangent
with first IC and mark point
C

IE is due to
the parallel
shift: SE on the SAME IC:
6-4 = 2 10-6 = 4
15

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Figure 4.8: Income and Substitution

Effects for an Inferior Good
You need to draw point D lower than
Y (R/wk) point A (e.g. 120 < 240)
Move the second budget line parallel
680 to the right to tangent with first IC
and mark point C
TE: 12-9 = 3 (smaller than SE)
480 SE: 12-8 = 4
SE>IE; SE dominates
360 IE offsets the SE

320

120

Maize porridge
(kg/wk)

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Fig 4.7: SE & IE: Normal Good

Please refer to your workbook:

◦Class activity: Unit 1.3 (page 6 Adjusted
workbook)
◦Activity 1

Fig 4.8: SE & IE: Inferior Good

Please refer to your workbook:

◦Class activity: Unit 1.3 (Page 6)
◦Activity 2

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Summary: IE, SE and TE

Price  Normal Good Inferior good
()
SE P () ~ Qd() P () ~ Qd ()
Negative Negative

IE P () ~ Y () ~ P () ~ Y () ~

Qd() Qd()
Negative Positive

TE Negative IE reinforces the Negative SE > Positive IE =

negative SE = negative TE Negative TE

Law of demand holds Law of demand holds

The EFFECT refers to the RELATIONSHIP between P and Q…and
not the direction of Q per se!

5. Elasticity & Total Expenditure

 Price elasticity of demand:

◦ The % change in Qd as a result of a 1% change in
the price
◦ Elastic → |ε| > 1
◦ Inelastic → |ε| < 1
◦ Unitary elastic → |ε| = 1

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5.1 Ed: The point-slope method:

 Elasticity
at a certain point (P & Q) on the
demand curve.
 P = a – bQ

𝑷 𝟏
𝑬𝒅
𝑸 𝑺𝒍𝒐𝒑𝒆 MUST be negative!

𝑻𝒐𝒕𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝑷 𝑸

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Class activity
 Please refer to your workbook:
 Class activity: Unit 1.3
 Activity 3 (page 6)
P = 1600-2Q

Calculate Ed & TE @ P = 1200

1200 = 1600 – 2 Q
Q = 200
Ed = 1200/200 * 1/slope
= 6* 1/-2
= -3
Absolute 3 >1, thus elastic
TE = P*Q
=1200 * 200
= 240 000

Class activity
Calculate Ed & TE @ Q = 500 given P = 1600 - 2 Q
P = 1600 – 2 (500)
P = 600
Ed = 600/500 * 1/slope
= 1.2 *1/-2
= - 0.6
Absolute terms 0.6 < 1, thus inelastic
TE = P*Q
= 600 * 500
= 300000

5.2 Ey: The point-slope method

 Elasticity of a certain point (Y & Q) on an Engel curve

 Linear income function: Y = a + bQ

 Income elasticity of demand =

𝒀 𝟏
E𝒚 𝑸 𝑺𝒍𝒐𝒑𝒆

◦ Ey positive and > 1 = luxury product e.g. = 2

◦ Ey positive and < 1 = necessity e.g. = 0.2
◦ Ey negative = inferior product e.g. = -2

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Class Activity

 Please refer to your workbook:

◦Class activity: Unit 1.3 (p6)
◦Activity 4
Y = 5 + 0.5 Q
if Q =6
Y = 5 +0.5 (6)
=8
Ey = 8/ 6 * 1/ 0.5
= 2.67…………Ey > 1, luxury good,
Engel curve?

Class Activity

◦Activity 4…continue
Y = 5 +0.5 Q ……….if Y = 50
50 = 5 +0.5 Q
Q = 90
Ey = 50/90 * 1/ 0.5
= 1.111
Ey > 1, luxury good
Ey < 1, necessity
{Suppose Y = 5 - 0.5 …the negative
slope indicates inferior product}

6. Consumer’s reaction on price

changes (Elasticity)
 Consumers react differently on price
changes
 Elastic vs. inelastic products
◦ Inelastic – salt
◦ Elastic – accommodation
 How can we use the IE and SE to explain
the reactions (elasticity)?
◦ Inelastic… small change in Q (also small change
in SE & IE)
◦ Elastic…… big change in Q (also big change in
SE & IE)
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6.1 Determinants of elasticity

 Substitutes:
◦ With poor or no substitutes, the SE is small
◦ With close substitutes the SE is large

 Portion of budget:
◦ Bigger portion of budget = IE large
◦ Smaller portion of budget = IE small

 Direction of income effect:

◦ Normal products are more elastic than inferior products
because the IE reinforces the SE

 Time: More elastic over the long run

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Elasticity (continued)

 Inelastic:
◦ No substitute products = small SE
 IC almost has a rectangular shape (low degree of substitution)
◦ Small % income = small IE
◦ Thus: Small SE + Small IE = Small TE

 Elastic:
◦ Has close substitute products = large SE
 IC has a smooth convex shape (high degree of substitution)
◦ Large % income = large IE
◦ Thus: Large SE + Large IE = Large TE
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7. Network externalities

 Network externalities: when one consumer

demand is dependent on another
consumer.

 Positive externalities: consumers buy more

because other consumers are buying it

 Negative externalities: consumers buy less

because other consumers are buying more.

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7.1 Positive network externality

 “Bandwagon” effect (BWE): the desire to buy a product
because everyone else owns the product.
◦ E.g. Children’s toys, technology

 “Pure price effect”: illustrates the actual change in

consumption due to a change in price.

 Total price effect = BWE + PPE

 Market demand curve is more elastic than individual demand

curve

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Fig 4.37: Positive network externality

Please refer to your workbook:

◦Class activity: Unit 1.3
◦Activity 5 (p7)
◦P drops 2000 – 1500
◦PEE = 500 (350 to 850)
◦BWE = 300 (850 t0 1150)
◦TE = 800 (500 & 300)
◦Market demand is ELASTIC
You must be able to calculate and show on your graph the
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exact change for each effect.

7.2 Negative network externality

 “Snob”- effect: if less people own the product,
the higher the demand for the product
◦ High prestige value attached to the product
◦ Desire to own a unique/exclusive product
 E.g. Rare artwork, specialist sports cars

 Total price effect = Snob-effect + PPE

 Market demand curve is more inelastic than the

individual demand curve
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Fig. 4.38: Negative network externality

Please refer to your workbook:

◦Class activity: Unit 1.3
◦Activity 6
◦P drops 600 – 400
◦PEE = 400 (200 to 600)
◦SE (snob effect) = -300 (600 back to
300)
◦TE = 100 (400 - 300)
◦Market demand is INELASTIC

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