1. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. (a) Individual 1 PXPX X P* X* 1 0 FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves

2. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. (a) Individual 1 PXPX X P* X* 1 0 (b) Individual 2 X* 2 0 FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves PXPX

3. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Construction of the Market Demand Curve –The total quantity demanded at the market at P * X is the sum of the two amounts: X * = X * 1 + X * 2. The point X *, P * X is one point on the market demand curve. The other points on the curve are similarly plotted.

4. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. (a) Individual 1 PXPX X P* X* 1 0 (b) Individual 2 X* 2 0 (c) Market Demand X D X*0 FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves PXPX PXPX

5. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Shifts in the Market Demand Curve To discover how some event might shift a market demand curve, we must first find out how this event causes individual demand curves to shift and then compare the horizontal sum of these new demand curves with the old demand curve.

6. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Shifts in the Market Demand Curve For example consider the two buyer case where both consumers regard X as a normal good. An increase in income for each consumer would shift their individual demand curves out so that the market demand curve, would also shift out This situation is shown in Figure 4.2

7. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. (a) Individual 1 PXPX X P* X* 1 0 (b) Individual 2 X* 2 0 (c) Market Demand X D X*0 FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward PXPX PXPX

8. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. (a) Individual 1 PXPX X P* X* 1 0 (b) Individual 2 X* 2 0 (c) Market Demand X D X*0 FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward PXPX PXPX X** D’ 12

9. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Shifts in the Market Demand Curve However, some events result in ambiguous outcomes. –If one consumer’s demand curve shifts out while another’s shifts in, the net effect depends on the size of the relative shifts. An increase in income for pizza lovers would increase the market demand for pizza so long as it is a normal good.

10. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Shifts in the Market Demand Curve On the other hand, if the increase in income was for people who don’t like pizza, there would be no significant effect on the market demand curve for pizza. Changes in the prices of related goods, substitutes or complements, will also shift the individual and market demand curves.

11. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Shifts in the Market Demand Curve If goods X and Y are substitutes, an increase in the price of Y will increase the demand for X. Similarly, a decrease in the price of Y will decrease the demand for X. If goods X and Y are complements, an increase in the price of Y will decrease the demand for X. A decrease in the price of Y will increase the demand for X.

12. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.1: Consumption and Income Taxes People’s ability to purchased goods and services is dependent upon their after tax income. In the 1950’s Milton Friedman argued that people’s consumption decisions are based mostly on their long-term (permanent) income.

13. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.1: Consumption and Income Taxes One implication of the permanent-income hypothesis is that temporary tax changes will have little effect on the demand for consumption goods –This prediction is supported by the small impact on consumption by both the temporary tax surcharge during the Nixon administration and the Ford administration’s temporary income tax rebate

14. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.1: Consumption and Income Taxes Permanent changes in taxes, however, should have an impact on consumption. –The tax cuts during the early years of the Reagan administration did not have a significant impact on consumption until later when consumers decided they were permanent. –Alternatively Bush’s tax increase, breaking his “read my lips” pledge not to raise taxes, had an immediate negative impact on consumption.

15. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. A Word on Notation and Terms When looking at only one market, Q is used for the quantity of the good demanded, and P is used for its price. When drawing the demand curve, all non- price factors are assumed to not change. Movements along the curve are changes in quantity demanded, while shifts are changes in demand.

16. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Elasticity Goods are often measured in different units (steak is measured in pounds while oranges are measured in dozens). It can be difficult to make simple comparisons between goods when trying to determine which is more responsive to changes in price.

17. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Elasticity Elasticity is a measure of the percentage change in one variable brought about by a 1 percent change in some other variable. Since it is measured in percentages, the units cancel out so that it is a unit-less measure of responsiveness.

18. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity of Demand The price elasticity of demand is the percentage change in the quantity demanded of a good in response to a 1 percent change in its price

19. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity of Demand The price elasticity records how Q changes in percentage terms in response to a percentage change in P. Since, on a typical demand curve, P and Q move in oppositely, e Q,P will be negative. For example, if e Q,P = -2, a 1 percent increase in price leads to a 2 percent decline in quantity.

20. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Values of the Price Elasticity of Demand When e Q,P < -1, a price increase causes more than a proportional quantity decrease and the curve is called elastic. When e Q,P = -1, a price increase causes a proportional quantity decrease, and the curve is called unit elastic When e Q,P > -1, a price increase causes less than a proportional quantity decrease, and the curve is called inelastic.

21. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 4.1: Terminology for the Ranges of e Q,P

22. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and the Shape of the Demand Curve We often classify market demand curves by their elasticities –For example, the market demand curve for medical services is inelastic (nearly vertical) since there is little quantity response to changes in price. –Alternatively, the market demand curve for a single type of candy bar is very responsive to price change (nearly flat) and is very elastic.

23. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and the Substitution Effect Goods which have many close substitutes are subject to large substitution effects from a price change so their market demand curve is likely to be relatively elastic. Goods with few close substitutes, on the other hand, will likely be relatively inelastic.

24. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and the Substitution Effect There is also an income effect that will determine how responsive quantity demanded is to changes in price. However, since changes in the prices of most goods have a small effect on individuals’ real incomes, the income effect will likely not have as large an impact on elasticity as the substitution effect.

25. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and Time Some items can be quickly substituted for, such as a brand of breakfast cereal, others, such as heating fuel, may take several years. Thus, in some situations, it is important to make the distinction between the short-term and long-term elasticities of demand.

26. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.2: Brand Loyalty Substitution due to price changes will likely take a longer time if individual’s develop spending habits. Such brand loyalties are rational since they reduce decision making costs. Over the long term, however, price differences may cause buyers to try other brands.

27. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.2: Brand Loyalty It took several years, but by the 1970s the price differences between U.S. and Japanese cars eventually convinced Americans to buy the Japanese cars. Brand name Licensing, such as Coca-Cola sweatshirts and Mickey Mouse watches, makes products that were previously nearly perfect substitutes, now much less so.

28. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and Total Expenditures Total expenditures on a good are found by multiplying the good’s price (P) times the quantity purchased (Q). When demand is elastic, price increases will cause total expenditures to fall. –The given percentage increase in price is more than counterbalanced by the decrease in quantity demanded.

29. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and Total Expenditures For example suppose price elasticity = -2. –Suppose people buy 1 million automobiles at $1000 each for a total expenditure of $10 billion. –A price increase to $11,000 (10 percent) would cause a 20 percent decline in quantity to 800,000 vehicles. –Total expenditures after the price increase would now be only $8.8 billion

30. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and Total Expenditures Of course, when demand is elastic and prices fall, total expenditures increase. With unit elasticity, total expenditures remain the same with a price change. –The movement in one direction by the price is fully offset by the movement in the other direction with the quantity demanded.

31. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and Total Expenditures When demand is inelastic, a price increase will cause total expenditures to increase too. Suppose the price elasticity of wheat = -0.5. –Suppose people bought 100 million bushels at $3 per bushel so total expenditures equal $300 million.

32. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price Elasticity and Total Expenditures –A 20 percent price increase to $3.60 means quantity falls by 10 percent to 90 million with total expenditures now equal to $324 billion. Alternatively, if the demand is inelastic and prices fall, total revenue will also fall. Table 4.2 summarizes the relationship between price elasticity and total expenditures.

33. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 4.2: Relationship between Price Changes and Changes in Total Expenditure

34. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.3: Volatile Farm Prices The demand for many basic agricultural products (wheat, corn, etc.) is relatively inelastic. Even modest changes in supply, brought about by weather patterns, can have large effects on crop prices.

35. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Boom and Bust in the Late 1990s Since the New Deal in the 1930s, the volatility of farm prices has been moderated through federal price-support programs. –Acreage restrictions constrained increased planting –The federal government purchased crops outright

36. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Boom and Bust in the Late 1990s These programs moderated severe farm price swings. With the passage of the Federal Agricultural Improvement and Reform Act in 1996, federal governmental intervention into agricultural markets was reduced. –In 1997, farm prices were unusually high, but this was followed by very low prices in 1998.

37. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Price (dollars) 10 50 40 30 25 20 Quantity of Walkmans per week Demand 2040506080100 0 FIGURE 4.3: Elasticity Varies along a Linear Demand Curve

38. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 4.3: Price, Quantity, and Total Expenditures on Walkmans for the Demand Function Q = 100 - 2P

39. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Numerical Example of Elasticity on a Straight Line Demand Curve For prices of $50 or more, nothing is bought so total expenditures are $0. As prices fall between $50 and $25, the midpoint, total expenditures increase. At the midpoint, total expenditures reach a maximum. As prices fall below $25, total expenditures also fall.

40. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Elasticity of a Straight Line Demand Curve More generally, for a linear demand curve of the form Q = a - bP,

41. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Income Elasticity of Demand The income elasticity of demand equals the percentage change in the quantity demanded of a good in response to a 1 percent change in income. The formula is given by (where I represents income):

42. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Income Elasticity of Demand For normal goods, e Q,I is positive because increases in income lead to increases in purchases of the good. For inferior goods e Q,I is negative. If e Q,I > 1, the purchase of the good increases more rapidly than income so the good might be called a luxury good.

43. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Cross-Price Elasticity of Demand The cross-price elasticity of demand measures the percentage change in the quantity demanded of a good in response to a 1 percent change in the price of another good. Letting P’ be the price of another good,

44. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 4.4: Representative Price and Income Elasticities of Demand

45. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Some Cross-price Elasticity Estimates Table 4.5 shows a few cross-price elasticity estimates All of the goods appear to be substitutes and have positive cross-price elasticities.

46. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. TABLE 4.5: Representative Cross- Price Elasticities of Demand

47. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. APPLICATION 4.4: The Economics and Politics of Health Insurance Most developed countries have some form of national health insurance. –In the U.S. Medicare covers the elderly and Midicaid is available for many of the poor. Recently a number of comprehensive government health plans have been proposed.

48. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. The Moral Hazard Problem A “moral hazard” problem occurs because insurance misleadingly lowers the out-of- pocket expenses to patients, greatly increasing their demand for medical services. An important question, in considering implementing national health insurance is how large an increase is likely to develop?

49. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Low Elasticities for Hospital and Doctors’ Visits Using the estimate of -0.22 found in Table 4.4, and based on other studies suggests only a small increase in hospital and doctor visits would result from the lower prices provided by insurance. Alternatively, researchers have found greater elasticities (around -0.5) for dental care and outpatient mental health care.

50. Copyright (c) 2000 by Harcourt, Inc. All rights reserved. The Politics of Elatically Demanded Services Political pressure to include psychiatric and other services greatly increased the price of the 1994 Clinton Health Care Plan and contributed to the defeat of the bill. Recent proposals to have Health Main- tenance Organizations provide services at zero out-of-pocket costs threaten to reverse cost savings the HMOs have achieved.