Chapter 4 - Demand and elasticity. We begin in chapter 4 by exploring the concept of elasticity, which describes the sensitivity of demand and supply to variations in prices, incomes, and other economic factors.
Chapter 4: Demand and Elasticity Relate the law of demand to the Cost-Benefit Principle Discuss the relationship between the individual demand curve and the market demand curve Define and calculate consumer surplus Define price elasticity of demand and explain its determinants Calculate price elasticity of demand using information from the demand curve Describe the relationship between price elasticity of demand and total expenditure Define cross-price elasticity of demand and income elasticity of demand McGrawưHill/Irwin Copyrightâ2011byTheMcGrawưHillCompanies,Inc.Allrightsreserved Law of Demand Cost-Benefit Principle at work – Do something if the marginal benefits are at least as great as the marginal costs • An increase in the market price approaches our reservation price – If market price exceeds the reservation price, buy no more – Costs include ALL costs – money, time, reputation • Consider implicit and explicit costs Law of Demand People less of what they want to as the cost of doing it rises 42 Origins of Demand • Reservation price – Individual tastes and preferences differ Biological needs Peer behavior Perceived quality Cultural influences ■ Individual differences ■ Expected benefits ■ – Tastes may change over time • Macaroni and cheese • Spinach • New goods get incorporated into priorities 43 Needs versus Wants • Some goods are required for subsistence – These are needs • Beyond subsistence, behavior is driven by wants – Kidneys or hamburger – Oatmeal or toaster pastries • Wants depend on price – Water in California • Regulations or price mechanism – Regulations are cumbersome and expensive – Price changes are fast and effective 44 Substitution at Work • Substitution has powerful effects on our choices – New car or used one – Car pool or bus – French restaurant, Chinese restaurant, cook at home – Soccer game or TV or read a book – Go to movies or join Netflix or get cable TV – Turn on the heat or put on a hoodie 45 Nominal and Real Prices • Nominal price: the absolute price of a good in terms of dollars – The price you see on a good in a store • Real price: the nominal price of a good relative to the average dollar price of all other goods – Real prices are adjusted for inflation 46 Income Differences Matter • Income is one of the determinants of demand – "Free goods" have more takers in lower income neighborhoods than in higher income areas • The wait to get the free good is the price – Waiting times in lower income areas will be longer » Lower opportunity cost of the residents' time – Stores in higher income areas have lower waiting times to pay for purchases • The higher value of time causes these people to be willing to pay for more store staff 47 Individual and Market Demand Curves • The market demand is the horizontal sum of individual demand curves – At each possible price, add up the number of units demanded by individuals to get the market demand Smith Jones Market 48 Identical Individual Demand Curves • In the special case where all buyers demand exactly the same quantity at each price – Multiply the individual quantity demanded by the number of buyers to get the market demand Individual Market 49 • Consumer surplus is the difference between the buyer's reservation price and the market price • When a product is sold in whole units, the demand curve is a stair-step function • Many goods are indivisible: movie tickets and TVs – If the market supplied only one unit, the maximum price would be $11 • For the second unit, the price is $10, and so on • The last buyer gets no consumer surplus Marginal utility (utils/ pint) Consumer Surplus on a Graph Vanilla Ice Cream 12 11 10 D 10 Units/day 12 410 • Market price is $6 for all sales • Total consumer surplus • The first sale generates $5 of consumer surplus – Reservation price of $11 minus the price of $6 • Selling the second unit has $4 of consumer surplus, and so on • Total consumer surplus is the area under the demand curve and above market price Marginal utility (utils/ pint) Consumer Surplus on a Graph Vanilla Ice Cream 12 11 10 D 10 Units/day 12 411 Price Elasticity of Demand • Price elasticity of demand is defined as the percentage change in quantity demanded from a 1% change in price – Measure of responsiveness of quantity demanded to changes in price • Example: – Price of beef decreases 1% – Quantity of beef demanded increases 2% – Price elasticity of demand is – P Q 412 Calculate Price Elasticity • Symbol for elasticity is ε – Lower case Greek letter epsilon • For small percentage changes in price ε= Percentage change in quantity demanded Percentage change in price Price elasticity of demand is always negative Ignore the sign 413 Elastic Demand If price elasticity is greater than 1, demand is elastic – Percentage change in quantity is greater than percentage change in price – Demand is responsive to price Inelastic Demand • If price elasticity is less than 1, demand is inelastic – Percentage change in quantity is less than percentage change in price – Quantity demanded is not very responsive to price Unit Elastic Demand • If price elasticity is 1, demand is unit elastic – Price and quantity change by the same percentage 414 Price Elasticity Notation • ΔQ is the change in quantity – ΔQ / Q is percentage change in quantity • ΔP is change in price – ΔP / P is percentage change in price ΔQ / Q ε= ΔP / P 415 Price Elasticity: Graphical View P=8 Q=3 Slope = 20 / = ε= ε= P x Q x Price • At point A A P ΔP P–ΔP ΔQ D slope = 0.67 Q Q+ΔQ Quantity 416 Price Elasticity and Slope • When two demand curves cross – At the common point demand is less price elastic for the steeper curve Price • P / Q is same for both curves • (1 / slope) is 12 smaller for the D1 steeper curve Less Elastic More Elastic D2 Quantity 12 417 Price Elasticity on a StraightLine Demand Curve • Price elasticity is different at each point ε= P Q x slope – Slope is the same for the demand curve – P/Q decreases as price goes down and quantity goes up 418 Price Elasticity Pattern • Price elasticity changes systematically as price goes down • At high P and low Q, P / Q is large • Demand is elastic • Demand is inelastic a Price • At the midpoint, demand is unit elastic • At low P and high Q, P / Q is small 1 a/2 b/2 Quantity b 419 Two Special Cases Perfectly Elastic Demand Perfectly Inelastic Demand • Infinite price elasticity of demand • Zero price elasticity of demand Price Price D D Quantity Quantity 420 Elasticity and Total Expenditure • When price increases, total expenditure can increase, decrease or remain the same – The change in expenditure depends on elasticity • Terminology: total expenditure = total revenue – Calculate as P x Q • Graphing idea: total expenditure is the area of a rectangle with height P and width Q – Example: P = and Q=4 Price Expenditure = D Quantity 421 Price Elasticity and Total Expenditure • Movie ticket price increases from $2 to $4 – A and B are both below the midpoint of the curve • Inelastic portion of the demand curve – Total revenue increases when price increases D 12 Expenditure = $1,000/day Price ($/ticket) Price ($/ticket) 12 Expenditure = $1,600/day B A D Quantity (00s of tickets/day) Quantity (00s of tickets/day) 422 Price Elasticity and Total Expenditure • Movie ticket price increases from $8 to $10 – Prices are both above the midpoint of the curve • Elastic portion of the demand curve – Total revenue decreases Y Expenditure = $1,600/day D Quantity (00s of tickets/day) 12 10 Z Price ($/ticket) Price ($/ticket) 12 Expenditure = $1,000/day D Quantity (00s of tickets/day) 423 Cross-Price Elasticity of Demand • Substitutes and complements affect demand • Cross-price elasticity of demand is defined as the percentage change in quantity demanded of good A from a percent change in the price of good B • Sign of cross-price elasticity shows relationship between the goods – Complements have negative cross-price elasticity – Substitutes have positive cross-price elasticity Income Elasticity of Demand • Income elasticity of demand is defined as the percentage change in quantity demanded from a percent change in income • Income elasticity of demand can be positive or negative – Positive income elasticity is a normal good – Negative income elasticity is an inferior good 424 ... of tickets/day) 4 23 Cross-Price Elasticity of Demand • Substitutes and complements affect demand • Cross-price elasticity of demand is defined as the percentage change in quantity demanded of. .. Units/day 12 4 11 Price Elasticity of Demand • Price elasticity of demand is defined as the percentage change in quantity demanded from a 1% change in price – Measure of responsiveness of quantity... reputation • Consider implicit and explicit costs Law of Demand People less of what they want to as the cost of doing it rises 4 2 Origins of Demand • Reservation price – Individual tastes and