3 3 consumer choice, market demand, and elasticity

Consumer Choice, Market Demand, and Elasticity

● 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

● 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

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

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

Number of pints per Month

6 5 4 3 2 1

● 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

1 $.50

Number of pints purchased

8 7 6 5 4 3 2 1

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

Quantity Demanded 7 0

M Market demand

Quantity Demanded 3 0

Z Joe’s demand

Quantity Demanded

M M J J L L

Leah’s demand

● 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

● 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

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.

Elasticity = 0

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 =

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.

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”

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

Quantity Demanded

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

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 =

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 =

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.

3 3 consumer choice, market demand, and elasticity

demand utility

demand elasticity

marginal utility slide

demand income

individual demand curves

elasticity slide

law of demand scarcity

law of demand outline

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