3 3 consumer choice, market demand, and elasticity

3

Consumer Choice, Market Demand, and Elasticity

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

● Scarcity and Demand

● Utility: A Tool to Analyze Purchase Decisions

● Consumer Choice as a Trade-off: Opportunity Cost

● From Individual Demand Curves to Market Demand Curves

● Exceptions to the Law of Demand

● Scarcity and Demand

● Utility: A Tool to Analyze Purchase Decisions

● Consumer Choice as a Trade-off: Opportunity Cost

● From Individual Demand Curves to Market Demand Curves

● Exceptions to the Law of Demand

OutlineOutline


● Price Elasticity of Demand

● Its Effect on Total Revenue

● What Determines Demand Elasticity?

● Elasticity as a General Concept

● Price Elasticity of Demand

● Its Effect on Total Revenue

● What Determines Demand Elasticity?

● Elasticity as a General Concept

OutlineOutline


Scarcity and DemandScarcity and Demand

● Income is limited → consumers face constraints on their choices

● Wealthy and poor individuals have limited incomes relative to their desires.

● Every decision has an opportunity cost. ♦ ↑purchases of clothing → ↓purchases of restaurant

meals

● Income is limited → consumers face constraints on their choices

● Wealthy and poor individuals have limited incomes relative to their desires.

● Every decision has an opportunity cost. ♦ ↑purchases of clothing → ↓purchases of restaurant

meals


Utility: A Tool to Analyze Purchase DecisionsUtility: A Tool to Analyze Purchase Decisions

● How do consumers make choices?♦ Theory of consumer choice = each consumer spends

his or her income in a way that yields the greatest satisfaction or utility.

♦ Cannot measure utility (or satisfaction) directly.

How should we measure your utility of a movie theater ticket?

● How do consumers make choices?♦ Theory of consumer choice = each consumer spends

his or her income in a way that yields the greatest satisfaction or utility.

♦ Cannot measure utility (or satisfaction) directly.

How should we measure your utility of a movie theater ticket?


● Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦ E.g., I will buy 7 pints of Chunky Monkey only if it costs

$21.50 or less. So the TU (or benefit) that I receive from 7 pints is $21.50.

● Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦ E.g., if I consumed 6 pints of Chunky Monkey, MU measures

how much add. satisfaction I get by consuming 7 pints instead.

● Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦ E.g., I will buy 7 pints of Chunky Monkey only if it costs

$21.50 or less. So the TU (or benefit) that I receive from 7 pints is $21.50.

● Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦ E.g., if I consumed 6 pints of Chunky Monkey, MU measures

how much add. satisfaction I get by consuming 7 pints instead.

Total vs. Marginal UtilityTotal vs. Marginal Utility

TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey

TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey

Quantity(per month)

Total Utility(dollars)

Marginal Utility(dollars)

Label forgraph

0 0.00 ------ ------

1 6.00 6.00 A

2 11.00 5.00 B

3 15.00 4.00 C

4 18.00 3.00 D

5 20.00 2.00 E

6 21.00 1.00 F

7 21.50 0.50 G

8 21.50 0.00 H



● TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc.

● MU: 1st pint is worth $6 to me and 2nd pint is worth $5.00 to me, while the 3rd is worth $4.00, etc.

● TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc.

● MU: 1st pint is worth $6 to me and 2nd pint is worth $5.00 to me, while the 3rd is worth $4.00, etc.

FIGURE 1. Leah’s Marginal Utility Curve for Chunky Monkey

FIGURE 1. Leah’s Marginal Utility Curve for Chunky Monkey

Number of pints per Month

8

Mar

gin

al U

tilit

y (P

rice

) p

er p

int

6

5

4

$3

2

1

0 7

H

F

E

D

C

B

A

6 5 4 3 2 1

$7

G

Price


● Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction.

● Additional units of a good are worth less and less to a consumer in money terms.♦ E.g., each add. pint is worth less to me. 1st pint eat by myself;

2nd share with my husband; 3rd share with my friend; 4th share with my dog, Dante; 5th share with my mother-in-law. Thus, each successive pint has a lower priority.

Can you think of any exceptions to the law of diminishing marginal utility?

● Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction.

● Additional units of a good are worth less and less to a consumer in money terms.♦ E.g., each add. pint is worth less to me. 1st pint eat by myself;

2nd share with my husband; 3rd share with my friend; 4th share with my dog, Dante; 5th share with my mother-in-law. Thus, each successive pint has a lower priority.

Can you think of any exceptions to the law of diminishing marginal utility?

“Law” of Diminishing MU“Law” of Diminishing MU



● Graph of MU has (-) slope → ↓MU as ↑Qd.

● ↑TU as long as MU is (+). ♦ E.g., when a commodity is very scarce (diamonds),

economists expect it to have high MU even though it provides very little TU.

Can you think of a good that has a very low MU but a very high TU?

● Graph of MU has (-) slope → ↓MU as ↑Qd.

● ↑TU as long as MU is (+). ♦ E.g., when a commodity is very scarce (diamonds),

economists expect it to have high MU even though it provides very little TU.

Can you think of a good that has a very low MU but a very high TU?


Using MU: The Optimal Purchase RuleUsing MU: The Optimal Purchase Rule

How many pints of Chunky Monkey should I purchase?● Goal: max. total benefit from pints while min. their cost.

As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money.

● Net TU = TU – total expenditure; where TE = P*Qd.● Max. net TU by watching net MU; net MU = MU – P.

♦ E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more.

How many pints of Chunky Monkey should I purchase?● Goal: max. total benefit from pints while min. their cost.

As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money.

● Net TU = TU – total expenditure; where TE = P*Qd.● Max. net TU by watching net MU; net MU = MU – P.

♦ E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more.


Using MU: The Optimal Purchase RuleUsing MU: The Optimal Purchase Rule

● Two rules govern the optimal purchase rule:1. if net MU is (+) (or MU > P) → consumer buys too

little of the good to max. net TU2. if net MU is (-) (or MU < P) → consumer buys too

much of the good to max. net TU

● Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P).

MU = P is the optimal purchase rule

● Two rules govern the optimal purchase rule:1. if net MU is (+) (or MU > P) → consumer buys too

little of the good to max. net TU2. if net MU is (-) (or MU < P) → consumer buys too

much of the good to max. net TU

● Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P).

MU = P is the optimal purchase rule


● Demand curve = MU curve♦ Law of diminishing MU (-) slope of D curves P Qd MU

■ E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law.

● Demand curve = MU curve♦ Law of diminishing MU (-) slope of D curves P Qd MU

■ E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law.

From MU to Demand CurvesFrom MU to Demand Curves


Consumer Choice as a Trade-Off: Opportunity CostConsumer Choice as a Trade-Off: Opportunity Cost

● Recall the importance of opportunity cost● Decision to purchase something decision to forgo

something else♦ Real cost of 4 pints purchased for $3.00 each is not the $12

given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey.

● Recall the importance of opportunity cost● Decision to purchase something decision to forgo

something else♦ Real cost of 4 pints purchased for $3.00 each is not the $12

given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey.


Consumer Surplus Consumer Surplus

● CS = net TU = TU - TE

● Economists assume that firms max profit and consumers max CS.

● Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good.

● CS = net TU = TU - TE

● Economists assume that firms max profit and consumers max CS.

● Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good.

TABLE 2. Calculating CSTABLE 2. Calculating CS

Quantity(pints per mo.)

Marginal Utility Price Net MU (per unit surplus)

1 $ 6.00 $ 3.00 $ 3.00

2 5.00 3.00 2.00

3 4.00 3.00 1.00

4 3.00 3.00 0.00

5 2.00 3.00 -1.00

Two ways of calculating CS:

(1) CS = TU – TE or (2) CS = ∑(MU – P)

FIGURE 2. Graph of CSFIGURE 2. Graph of CSM

arg

inal

Uti

lity

and

Pri

ce p

er p

int

$0

6

5

4

3

2

1 $.50

$1

$2

0

Number of pints purchased

8 7 6 5 4 3 2 1

7

$6

$3

A

B

C

$5

$4

$3D

E

F

GH

$2$1

P$0

MU

CS per unit MU (or D) curve


Graph of Consumer SurplusGraph of Consumer Surplus

● CS = area under D curve and above P. ♦ Leah was willing to pay $18 for the 4 pints (i.e., the

TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6.

● TU = area under entire D curve

● TE = rectangular area that reflects P*Qd

● CS = area under D curve and above P. ♦ Leah was willing to pay $18 for the 4 pints (i.e., the

TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6.

● TU = area under entire D curve

● TE = rectangular area that reflects P*Qd


● Market D curve = horizontal sum of individual D curves

● Steps to move from individual D to market D:1. Pick any relevant P.

2. Find Qd at that P for each person.

3. Add the Qd at that P to get Qd in the market.

Repeat these steps for all possible prices.

● Market D curve = horizontal sum of individual D curves

● Steps to move from individual D to market D:1. Pick any relevant P.

2. Find Qd at that P for each person.

3. Add the Qd at that P to get Qd in the market.

Repeat these steps for all possible prices.

From Individual to Market D CurvesFrom Individual to Market D Curves

FIGURE 3. Total Market D vs. Individual Consumer D

FIGURE 3. Total Market D vs. Individual Consumer D

Pri

ce

Pri

ce

4 3

(c)

Quantity Demanded 7 0

M

M Market demand

(b)

Quantity Demanded 3 0

Z

Z Joe’s demand

(a)

Quantity Demanded

Pri

ce

$3

4 0

M M J J L L

K

D

D

Leah’s demand

$7

1 1



● The “Law” of Demand♦ (-) slope for market D curves

■ Individual D curves have (-) slopes because of the law of diminishing MU

■ Lower P draws new customers into the market

● E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P.

● The “Law” of Demand♦ (-) slope for market D curves

■ Individual D curves have (-) slopes because of the law of diminishing MU

■ Lower P draws new customers into the market

● E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P.



● Exceptions to the “Law” of Demand♦ Goods whose quality is judged by price –if a ↓P

signals poor quality → ↓Qd ■ E.g., Bayer aspirin vs. generic brand aspirin

♦ Goods with snob appeal –some people buy expensive goods to advertise their wealth

■ E.g., Rolls Royce

● Exceptions to the “Law” of Demand♦ Goods whose quality is judged by price –if a ↓P

signals poor quality → ↓Qd ■ E.g., Bayer aspirin vs. generic brand aspirin

♦ Goods with snob appeal –some people buy expensive goods to advertise their wealth

■ E.g., Rolls Royce


● Elasticity = measure of the responsiveness of one variable to changes in another variable

● Price elasticity of demand = (%∆Qd) ∕ (%∆P)

● Elasticity = measure of the responsiveness of one variable to changes in another variable

● Price elasticity of demand = (%∆Qd) ∕ (%∆P)

Elasticity: Measure of ResponsivenessElasticity: Measure of Responsiveness


Elasticity: Measure of ResponsivenessElasticity: Measure of Responsiveness

● Governments, courts, and businesses need to understand the relationship between Qd and P

● If consumers respond sharply to ∆P → D is elastic

● If consumers are unresponsive to ∆P → D is inelastic

● Governments, courts, and businesses need to understand the relationship between Qd and P

● If consumers respond sharply to ∆P → D is elastic

● If consumers are unresponsive to ∆P → D is inelastic

FIGURE 4(a). Perfectly Inelastic Demand

FIGURE 4(a). Perfectly Inelastic Demand

Qd is 90 no matter the P.

%∆Qd = 0

Consumer purchases do not respond to ∆P.

E.g., goods with very low prices that are used with something else –salt or shoelaces. Or an essential medicine.

P D

QD0

90

Elasticity = 0

FIGURE 4(b). Perfectly Elastic Demand

FIGURE 4(b). Perfectly Elastic Demand

Slight ↑P → ↓Qd to 0.

%∆Qd = infinitely large

Consumer are completely responsive to ∆P.

E.g., Demand for a firm that produces an undifferentiated product.

Elasticity =

D

QD

P

$5

0

FIGURE 4(c). Straight-line DemandFIGURE 4(c). Straight-line Demand

Slope remains constant but ε is changing.

ε (a-b) = (2/3) (2/5) = 1.67

ε (c-d) = (2/6) (2/2) = 0.33

Moving down the D curve ε is getting smaller because average Q is rising while average P is falling.

D

P

a

b

c

d

6

4

3

1

2 4 5 7 QD

FIGURE 4(d). Unit-elastic DemandFIGURE 4(d). Unit-elastic Demand

Slope is changing but ε is constant and equal to 1.

ε (e-f) = (7/10.5) (10/15) = 1.0

Note: if ε = 1 → D is “unit elastic”

if ε > 1 → D is “elastic”

if ε < 1 → D is “inelastic”

D

P

QD

20

10

7 14

e

f


Elasticity of Demand and Total Revenue Elasticity of Demand and Total Revenue

● Firms want to know whether an ↑P will raise or lower their sales revenues.

♦ If D is elastic: ↑P → ↓TR♦ If D is unit elastic: ↑P → TR constant♦ If D is inelastic: ↑P → ↑TR

■Recall: TR = TE = P x Qd

● Firms want to know whether an ↑P will raise or lower their sales revenues.

♦ If D is elastic: ↑P → ↓TR♦ If D is unit elastic: ↑P → TR constant♦ If D is inelastic: ↑P → ↑TR

■Recall: TR = TE = P x Qd


Elasticity of Demand and Total RevenueElasticity of Demand and Total Revenue

● Further examples:♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and

TR are constant.♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and

↑TR. ♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and

↓TR.

● Further examples:♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and

TR are constant.♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and

↑TR. ♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and

↓TR.

FIGURE 5. An Elastic Demand CurveFIGURE 5. An Elastic Demand Curve

5

12

Quantity Demanded

Pri

ce

$6

1

2

3

4

4 0

U

W

D

D

R

T

S

V

Pt. S: TR = $24 = area of 0RST

Pt. V: TR = $60 = area of 0WVU

D is elastic as ↓P → ↑TR.

TABLE 3. Estimates of Price Elasticities

TABLE 3. Estimates of Price Elasticities


What Determines Demand Elasticity?What Determines Demand Elasticity?

1. Nature of the good: ♦ Necessities have very inelastic demands, while

luxuries have elastic demands.♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =

1.6.

What do these numbers mean?● 10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑

in P of restaurant meals → ↓restaurant dining by 16%.

1. Comes from the elasticity formula: %P * ε = %Qd

1. Nature of the good: ♦ Necessities have very inelastic demands, while

luxuries have elastic demands.♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =

1.6.

What do these numbers mean?● 10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑

in P of restaurant meals → ↓restaurant dining by 16%.

1. Comes from the elasticity formula: %P * ε = %Qd



2. Availability of a close substitute:♦ If consumers can buy a good substitute for a

product whose ↑P, they will readily switch.■ E.g., D for gas is inelastic because you can’t run a car

without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.

2. Availability of a close substitute:♦ If consumers can buy a good substitute for a

product whose ↑P, they will readily switch.■ E.g., D for gas is inelastic because you can’t run a car

without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.



3. Fraction of Income Absorbed:♦ Very inexpensive items have an inelastic demand.

Who will use more salt if the price falls?♦ Very expensive items have elastic demands.

Families will buy fewer homes if housing prices increase.

3. Fraction of Income Absorbed:♦ Very inexpensive items have an inelastic demand.

Who will use more salt if the price falls?♦ Very expensive items have elastic demands.

Families will buy fewer homes if housing prices increase.



4. Passage of Time:● D for products is more elastic in LR than SR because

consumers have more time to adjust their purchases.♦ E.g., suppose recent ↑P gas continues. In SR, consumers

may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.

4. Passage of Time:● D for products is more elastic in LR than SR because

consumers have more time to adjust their purchases.♦ E.g., suppose recent ↑P gas continues. In SR, consumers

may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.


Elasticity as a General ConceptElasticity as a General Concept

● Elasticity can be used to measure the responsiveness of anything to anything else.

● Income Elasticity:♦ Income elasticity of D = % Qd % Y

● Price Elasticity of Supply:♦ Price elasticity of S = % Qs % P

● Elasticity can be used to measure the responsiveness of anything to anything else.

● Income Elasticity:♦ Income elasticity of D = % Qd % Y

● Price Elasticity of Supply:♦ Price elasticity of S = % Qs % P


Cross Elasticity of DemandCross Elasticity of Demand

● Cross εd is used to determine whether two goods are compliments or substitutes. It is calculated as:

εcross = (%∆Qd good X) (%∆P good Y)

● Cross εd is used to determine whether two goods are compliments or substitutes. It is calculated as:

εcross = (%∆Qd good X) (%∆P good Y)



● Two goods are compliments if an ↑Qd for one

good → ↑Qd of the other good. ♦ E.g, ketchup and french fries or coffee and cream.

■ If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.

● Two goods are compliments if an ↑Qd for one

good → ↑Qd of the other good. ♦ E.g, ketchup and french fries or coffee and cream.

■ If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.



● Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦ E.g., ice cream and frozen yogurt or cans of salmon

and cans of tuna.■ If ↑P of ice cream → ↓purchases of ice cream and

↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.

● Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦ E.g., ice cream and frozen yogurt or cans of salmon

and cans of tuna.■ If ↑P of ice cream → ↓purchases of ice cream and

↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.



● Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.

● Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.

3 3 consumer choice, market demand, and elasticity

Documents

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