Behind the Demand Curve:Consumer choiceMicroeconomics

Explaining the law of demand

Substitution Effect of a change in the price of a good is … the change in the quantity of that good demanded

as the consumer substitutes the good cheaper good for

the more expensive good

Need pictures

Substitution effect

Eli has $6 so spend on snacks. Jellybeans cost $1/package and Gummy Worms cost $2/package.

What is the max amount of packages Eli can buy given he has to buy at least one jellybean and at least 1 gummy worms?

4 jelly beans and 1 gummy worms

What is the opportunity cost of one gummy worms?

1 gummy worm is 2 jellybeans

Substitution effect

The price of gummy worms falls to $1/package. Jelly beams remains the same.

What is the opportunity cost of one gummy worms?

One jelly beans

So, gummy worms are now less expensive, and Eli will substitute some gummy worms for jelly beans.

The substitution effect of a lower price creates an increase in quantity demanded.

Explaining the law of demand

Income effect of a change in the price of a good is … the change in the quantity of that good demanded

that results From a change in the consumer’s purchasing power

Need pictures

Income effect

Eli has $6 so spend on snacks. Jellybeans cost $1/package and Gummy Worms cost $2/package.

How many packages of jellybeans could Eli buy if he spends all his income on jellybean? Gummy worms?

6 packages jellybeans

3 packages gummy worms

Gummy worms are now $1 each. How many packages of gummy worms can he buy?

6 packages

Income effect

Eli’s income is the same. His purchasing power has increased. He now has the opportunity to buy more gummy worms.

Substitution effect + income effect = lower price creates an increase in quantity

demanded.

Exercises

Do CYU # 1 and TTT 1 an 2 on the handout

Defining and Measuring Elasticity

Price Elasticity of Demand is the ratio …

Ed = % QD (effect) / % P (cause)

Elastic = consumer relatively responsive to P

Inelastic = consumer unresponsive P

Calculating Price Elasticity of Demand (Ed)

The price of digital cameras increase by 1% and quantity demanded falls by 2%. What is the Ed?

Ed = -2%/1% = -2; absolute value of -2 = 2.

% Qd was twice as large as the % in P

Sensitive = Elastic

Calculating Price Elasticity of Demand (Ed)

The price of milk increases by 10% and quantity demanded falls by 5%.

Ed = -5%/10% = -1/2; absolute value = ½ or .5

% Qd was half as large as the % in P

Insensitive = Inelastic

Calculating EdComputing a % ∆ Between Two Numbers

% ∆ P= (New Price – Old Price/ Old Price) *100

% ∆ Qd= (New Quantity – Old Quantity/ Old Quantity) *100

The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut consumption from 20 to 19.

Calculating Ed

The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut consumption from 20 to 19.

%∆P = 100(New Price – Old Price/Old Price) = 100*(1.15 – 1)/1 = 15% increase

%∆Qd = 100(New Quantity – Old Quantity/Old Quantity) = 100(19-20)/20 = 5% decrease

Homer’s Price Ed for doughnuts = %∆Qd/ %∆P = 5%/15% = 1/3

Is Homer’s Ed elastic or inelastic?

Inelastic (fraction)

Calculating Ed Using the Mid Point MethodThe price of a college tuition increases from $20,000 to $24,000 per year. The college discovers

that the entering class of first-year students declined form 500 to 450.

%∆P = 100(New Price – Old Price)/Average Price) =

100*(24,000 – 20,000)/22,000 = 9.5 increase

%∆Qd = 100(New Quantity – Old Quantity)/Average Quantity) =

(450 – 500)/475 = -10.5% decrease

Price Ed for college tuition = %∆Qd/ %∆P = 9.5%/10.5% = .90

Is the price of college tuition elastic or inelastic?

Inelastic (fraction)

Price Elasticity of Demand

Price Elasticity of Demand is the consumer response (Qd) to a price change.

Ed = % change Qd/ % change P

Ed < 1 = demand inelastic Ed = 1 = demand Unit elastic Ed > 1 = demand elastic

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Q1

P1

D

“Perfectly inelastic demand” (one extreme case)

Consumers have NO response to higher or lower prices.

P

Q

P2

P falls by 10%

Q changes by 0%

Consumers’ price sensitivity: 0

D curve:

Elasticity: 0

vertical

CHAPTER 5 ELASTICITY AND ITS APPLICATION

D

“Perfectly elastic demand” (the other extreme)

Consumers immediately reduce consumption to zero.

P

Q

P1

Q1

P changes by 0%

Q changes by any %

Q2

P2 =Consumers’ price sensitivity:

D curve:

Elasticity: infinity

horizontal

extreme

Elastic v. Inelastic

Elastic

I nelastic

Elastic v. Inelastic

D curve closer to vertical (steeper) WILL BE

less elastic than a D curve closer to horizontal (flatter)

CHAPTER 5 ELASTICITY AND ITS APPLICATION

D

Unit Elastic Demand

P

QQ1

P1

Q2

P2

Q rises by 10%

10%

10%= 1

Price elasticity of demand =

% change in Q

% change in P=

P falls by 10%

Consumers’ price sensitivity:

Elasticity:

intermediate

1

D curve: intermediate slope

CHAPTER 5 ELASTICITY AND ITS APPLICATION

D

“Inelastic demand”

P

QQ1

P1

Q2

P2

Q rises less than 10%

< 10%

10%< 1

Price elasticity of demand =

% change in Q

% change in P=

P falls by 10%

Consumers’ price sensitivity:

D curve:

Elasticity:

relatively steep

relatively low

< 1

CHAPTER 5 ELASTICITY AND ITS APPLICATION

D

“Elastic demand”

P

QQ1

P1

Q2

P2

Q rises more than 10%

> 10%

10%> 1

Price elasticity of demand =

% change in Q

% change in P=

P falls by 10%

Consumers’ price sensitivity:

D curve:

Elasticity:

relatively flat

relatively high

> 1

Total Revenue

Total Revenue (TR) = Price (P) * Quantity Demanded (Qd)

P competes with Qd on TR

Who wins?

Depends!!

Price Effect

Price effect happens after a price increase when … Units sold sells at a higher P Revenue rises P and TR

Quantity Effect

Quantity effect happens after a price increase when … Fewer units are sold –m lower Qd Revenue is lower P and TR

P and Qd Effect Examples

P rises 1% and Qd decreases 5% Elastic or inelastic? Which effect is stronger? TR fall or rise?

P and Qd Effect Examples

P rises 10% and Qd decreases 5% Elastic or inelastic? Which effect is stronger? TR fall or rise?

P and Qd Effect Examples

P rises 10% and Qd decreases 10% Elastic or inelastic? Which effect is stronger? TR fall or rise?

Elasticity Along the Demand Curve

P Qd TR Pe of D

$0 70 $0

1 60 60

2 50 100

3 40 120

4 30 120

5 20 100

6 10 60

7 0 0

CHAPTER 5 ELASTICITY AND ITS APPLICATION

The Determinants of Price Elasticity: A Summary

Elastic Inelastic

Luxury Necessity

Available Substitute

Unavailable Substitute

Ample Time Available

Little Time Available

Large Portion of Income

Small Portion of Income

CHAPTER 5 ELASTICITY AND ITS APPLICATION

EXAMPLE 1:

Rice Krispies vs. Sunscreen The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why? Rice Krispies has lots of close substitutes

(e.g., Cap’n Crunch, Count Chocula), so buyers can easily switch if the price rises.

Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises.

Lesson: Price elasticity is higher when close substitutes are available.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

EXAMPLE 2:

“Blue Jeans” vs. “Clothing” The prices of both goods rise by 20%.

For which good does Qd drop the most? Why? For a narrowly defined good such as

blue jeans, there are many substitutes (khakis, shorts, Speedos).

There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for clothing, other than living in a nudist colony?)

Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

EXAMPLE 3:

Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why? To millions of diabetics, insulin is a necessity.

A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises,

some people will forego it.

Lesson: Price elasticity is higher for luxuries than for necessities.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

EXAMPLE 4:

Gasoline in the Short Run vs. Gasoline in the Long Run

The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? There’s not much people can do in the

short run, other than ride the bus or carpool. In the long run, people can buy smaller cars

or live closer to where they work.

Lesson: Price elasticity is higher in the long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Elasticity of a Linear Demand Curve

The slope of a linear demand curve is constant, but its elasticity is not.

P

Q

$30

20

10

$00 20 40 60

200%40%

= 5.0E =

67%67%

= 1.0E =

40%200%

= 0.2E =

Other Elasticities

Suppose the price of gasoline were to increase. Who would be interested?

Large trucks and SUVs, FEDEX, any business which relies on trucks to transport its goods

Cross-Price Elasticity is used to measure this response.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Other Elasticities Cross-Price Elasticity of Demand measures the response of

demand for one good to changes in the price of another good.

Cross-price elast. of demand

=% change in Qd for good 1

% change in P of good 2

Substitute - cross-price elasticity > 0

E.g., an increase in price of beef causes an increase in demand for chicken.

Complements - cross-price elasticity < 0 E.g., an increase in price of computers causes decrease in

demand for software.

Other Elasticities

Suppose the economy is suffering a recession and personal incomes are lower. Who would be interested?

Airlines and the hotel industries

Income Elasticity is used to measure this response.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Other Elasticities Income Elasticity of Demand (Ei)measures the response

of Qd to a change in consumer income.

Income elasticity of demand

=Percent change in Qd

Percent change in income

What is a normal good? Inferior good?

Normal goods – Ei > 0

Example: Consumer income rises by 4% and the quantity of fresh vegetables purchased increases by 1%.

Inferior goods - Ei < 0

Consumer income falls by 5% and consumers increase SPAM consumption by 4%

Other Elasticities

The Law of Supply says … P increases, Qs increases

Economists want to measure HOW MUCH Q will increase in response to this higher P.

Price Elasticity of Supply is used to measure this response.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

Price Elasticity of Supply Price elasticity of supply measures how much Qs responds to a

change in P.

Price elasticity of supply

=Percentage change in Qs

Percentage change in P

Es < 1 = demand inelasticEs = 1 = demand Unit elasticEs > 1 = demand elastic

Price Elasticity of Supply Factors

Availability of Inputs More elastic = inputs get into and out of production quickly

Time Period ‘Market period’ is short = Es is inelastic

‘Short-run supply’ more elastic than Market Period and less elastic than Long-run Supply.

‘Long-run supply’ is most elastic = longer time period to adjust