chapter 4 consumer decision making and consumer reaction to price changes
TRANSCRIPT
Chapter 4
Consumer Decision Making and Consumer Reaction to Price Changes
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Learning Objectives
• Distinguish between total and marginal utility.
• Distinguish between elastic and inelastic demand.
• Define the price elasticity of demand and state the formula for measuring it.
• List and describe three determinants of the price elasticity of demand.
• Explain the relationship between price elasticity of demand and consumer expenditures.
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If It Doesn’t Have Utility, You Won’t Buy It
• Everything for which you have a demand must generate satisfaction.
• Another way of describing satisfaction is utility, defined as want-satisfying power.
• The concept of utility is purely subjective.
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Measuring Utility
• In order to understand utility better, we arbitrarily define units of utility as utils.
• A util is an abstract concept that is defined as a representative unit by which utility is measured.
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Of Total and Additional Utility
• By definition, everything that you consume gives you some amount of satisfaction, or utility. If you watch ten movies a month, you get a certain amount of total utility from that activity over the month.
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Of Total and Additional Utility (cont.)
• But what about the additional utility you receive when you see another movie?
• We call this additional utility marginal utility, for which the word marginal means additional or incremental.
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Figuring Out Marginal Utility
• Marginal utility is the change in total utility as you increase your consumption rate.
• Assume your total utility from consuming two units of a given item is 16 utils, and your total utility from consuming three units is 19 utils. Then, the marginal utility of consuming the third unit is 19 minus 16, or 3 utils.
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Diminishing Marginal Utility
• According to the law of diminishing marginal utility, after you consume a good or service, the marginal utility you receive for yet more of that same good or service will start falling.
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Measuring Consumer Responsiveness
• If the price of salt goes down 50 percent, how much more salt would you purchase in a year? Probably not very much.
• In contrast, if you normally buy fast food dinners, and the price of fast food were to drop by 50 percent, you would probably increase the number of fast-food dinners you buy quite a bit.
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The Price Elasticity of Demand
• The official term for consumer responsiveness to price changes is price elasticity of demand.
• If consumers react a lot to a given percentage change in price, we say they have an elastic demand. If they do not react very much, we say they have an inelastic demand.
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Elasticity Calculations
• We measure the price elasticity of demand by comparing the percentage change in price with the percentage change in quantity demanded.
dPercentage change in QPrice elasticity of demand =
Percentage change in price
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Elasticity Calculations (cont.)
• For example, a price elasticity of demand for oil of –1 means that a 1 percent increase in the price of oil would lead to a 1 percent decrease in the quantity demanded of oil.
• Because of the law of demand, price elasticity of demand will always be negative.
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How We Actually Calculate Elasticity
• To calculate the price elasticity of demand, we have to compute percentage changes in quantity demanded and in relative price.
• However, there is an arithmetic problem when we calculate percentage changes with respect to the starting point. The percentage change from 2 to 3—50 %—is not the same as the percentage change from 3 to 2—33.3 %.
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Using Average Formulas
• A way out of this dilemma is to use average values.
• For relatively small changes in price, the formula for computing the price elasticity of demand then becomes
1 2 1 2
change in change in Price elasticity of demand =
( + ) 2 ( + ) 2
Q P
Q Q P P
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Price Elasticity Ranges
• Whenever the price elasticity of demand is numerically greater than one, we say that it is an elastic demand.
• If the price elasticity of demand is numerically less than one, we say that we are dealing with an inelastic demand.
• When demand is neither elastic nor inelastic, it is said to be unit-elastic demand.
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Factors that Determine the Price Elasticity of Demand
1. The Existence of Substitutes: The more substitutes that exist for a good, the more responsive consumers will be to a change in its price.
2. The Percentage of a Person’s Total Budget Devoted to the Purchase of that Good: The larger the percentage of your budget devoted to an item, the more price elastic will its demand be.
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Factors that Determine the Price Elasticity of Demand (cont.)
3. The Time Allowed for Adjustment: The longer the time allowed for adjustment to a price change, the more that consumers will react.
The longer any price change persists, the greater the elasticity of demand, other things held constant.
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Figure 4-3: Short-Run and Long-Run Price Elasticity of Demand
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Table 4-1: Selected Estimated Short and Long Run Price Elasticities of Demand
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Price Elasticity of Demand and Consumer Expenditures
• Suppose that you are in charge of the pricing decision for a cellular telephone service company. How would you know when it is best to raise or not to raise prices?
• The answer depends in part on the effect of your pricing decision on consumer expenditures—which become your total revenues or receipts—on your services.
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Price Elasticity of Demand and Consumer Expenditures (cont.)
• It is commonly thought that the way to increase total revenues is to increase price per unit.
• Is this always the case? Or is it possible that a price increase could lead to a decrease in consumer expenditures?
• The answers to these questions depend on the price elasticity of demand.
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Price Elasticity of Demand and Consumer Expenditures (cont.)
• When the firm faces a demand that is elastic, if it raises its price, total consumer expenditures will fall.
• When facing a unit-elastic demand, any small changes in price do not change consumer expenditures.
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Price Elasticity of Demand and Consumer Expenditures (cont.)
• When the firm is facing a demand that is inelastic, if it raises its price, consumer expenditures will go up; if it lowers its price, consumer expenditures will fall.
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Key Terms and Concepts
• elastic demand • elasticity • inelastic demand• marginal utility • price elasticity of
demand
• principle of diminishing marginal utility
• unit-elastic demand• utility • utils