McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Demand and Elasticity 1.Relate the law of demand to the Cost-Benefit Principle 2.Discuss the relationship between the individual demand curve and the market demand curve 3.Define and calculate consumer surplus 4.Define price elasticity of demand and explain its determinants 5.Calculate price elasticity of demand using information from the demand curve 6.Describe the relationship between price elasticity of demand and total expenditure 7.Define cross-price elasticity of demand and income elasticity of demand

4-2 Cost-Benefit Principle at work –Do something if the marginal benefits are at least as great as the marginal costs An increase in the market price approaches our reservation price –If market price exceeds the reservation price, buy no more –Costs include ALL costs – money, time, reputation Consider implicit and explicit costs Law of Demand Law of Demand People do less of what they want to do as the cost of doing it rises

4-3 Origins of Demand Reservation price –Individual tastes and preferences differ  Biological needs ■ Cultural influences  Peer behavior ■ Individual differences  Perceived quality ■ Expected benefits –Tastes may change over time Macaroni and cheese Spinach New goods get incorporated into priorities

4-4 Needs versus Wants Some goods are required for subsistence –These are needs Beyond subsistence, behavior is driven by wants –Kidneys or hamburger –Oatmeal or toaster pastries Wants depend on price –Water in California Regulations or price mechanism –Regulations are cumbersome and expensive –Price changes are fast and effective

4-5 Substitution at Work Substitution has powerful effects on our choices –New car or used one –Car pool or bus –French restaurant, Chinese restaurant, cook at home –Soccer game or TV or read a book –Go to movies or join Netflix or get cable TV –Turn on the heat or put on a hoodie

4-6 Nominal and Real Prices Nominal price: the absolute price of a good in terms of dollars –The price you see on a good in a store Real price: the nominal price of a good relative to the average dollar price of all other goods –Real prices are adjusted for inflation

4-7 Income Differences Matter Income is one of the determinants of demand –"Free goods" have more takers in lower income neighborhoods than in higher income areas The wait to get the free good is the price –Waiting times in lower income areas will be longer »Lower opportunity cost of the residents' time –Stores in higher income areas have lower waiting times to pay for purchases The higher value of time causes these people to be willing to pay for more store staff

4-8 Individual and Market Demand Curves The market demand is the horizontal sum of individual demand curves –At each possible price, add up the number of units demanded by individuals to get the market demand SmithJonesMarket

4-9 Identical Individual Demand Curves In the special case where all buyers demand exactly the same quantity at each price –Multiply the individual quantity demanded by the number of buyers to get the market demand MarketIndividual

4-10 Consumer Surplus on a Graph Consumer surplus is the difference between the buyer's reservation price and the market price When a product is sold in whole units, the demand curve is a stair-step function Many goods are indivisible: movie tickets and TVs –If the market supplied only one unit, the maximum price would be $11 For the second unit, the price is $10, and so on The last buyer gets no consumer surplus D Units/day Marginal utility (utils/ pint) Vanilla Ice Cream

4-11 Consumer Surplus on a Graph Market price is $6 for all sales Total consumer surplus The first sale generates $5 of consumer surplus –Reservation price of $11 minus the price of $6 Selling the second unit has $4 of consumer surplus, and so on Total consumer surplus is the area under the demand curve and above market price D Units/day Marginal utility (utils/ pint) Vanilla Ice Cream

4-12 Price Elasticity of Demand Price elasticity of demand is defined as the percentage change in quantity demanded from a 1% change in price –Measure of responsiveness of quantity demanded to changes in price Example: –Price of beef decreases 1% –Quantity of beef demanded increases 2% –Price elasticity of demand is – 2 P Q

4-13 Calculate Price Elasticity Symbol for elasticity is ε –Lower case Greek letter epsilon For small percentage changes in price ε = Percentage change in quantity demanded Percentage change in price  Price elasticity of demand is always negative  Ignore the sign

4-14 Elastic Demand If price elasticity is greater than 1, demand is elastic –Percentage change in quantity is greater than percentage change in price –Demand is responsive to price Inelastic Demand If price elasticity is less than 1, demand is inelastic –Percentage change in quantity is less than percentage change in price –Quantity demanded is not very responsive to price Unit Elastic Demand If price elasticity is 1, demand is unit elastic –Price and quantity change by the same percentage

4-15 Price Elasticity Notation ΔQ is the change in quantity –ΔQ / Q is percentage change in quantity ΔP is change in price –ΔP / P is percentage change in price ε = Percentage change in quantity demanded Percentage change in price ε = ΔQ / Q ΔP / P

4-16 Price Elasticity: Graphical View At point A P = 8 Q = 3 Slope = 20 / 5 = 4 ε = x = 0.67 P – Δ P Price P D A Q Q + Δ Q Δ Q Δ P Quantity ε = P Q slope 1 x

4-17 Price Elasticity and Slope When two demand curves cross P / Q is same for both curves (1 / slope) is smaller for the steeper curve –At the common point demand is less price elastic for the steeper curve D1D1 D2D Quantity Price Less Elastic More Elastic

4-18 Price Elasticity on a Straight- Line Demand Curve Price elasticity is different at each point –Slope is the same for the demand curve –P/Q decreases as price goes down and quantity goes up ε = P Q 1 slope x

4-19 Price Elasticity Pattern Price elasticity changes systematically as price goes down At high P and low Q, P / Q is large Demand is elastic At the midpoint, demand is unit elastic At low P and high Q, P / Q is small Demand is inelastic Price b/2 a/2 a b Quantity

4-20 Two Special Cases Perfectly Elastic Demand Infinite price elasticity of demand Perfectly Inelastic Demand Zero price elasticity of demand Price Quantity D Price Quantity D

4-21 Elasticity and Total Expenditure When price increases, total expenditure can increase, decrease or remain the same –The change in expenditure depends on elasticity Terminology: total expenditure = total revenue –Calculate as P x Q Graphing idea: total expenditure is the area of a rectangle with height P and width Q –Example: P = 2 and Q = 4 Price Quantity D 2 4 Expenditure = 8

4-22 Price Elasticity and Total Expenditure Movie ticket price increases from $2 to $4 –A and B are both below the midpoint of the curve Inelastic portion of the demand curve –Total revenue increases when price increases Quantity (00s of tickets/day) D A Expenditure = $1,000/day 12 Price ($/ticket) 56 2 Quantity (00s of tickets/day) 4 D B Expenditure = $1,600/day 12 Price ($/ticket) 6 4

4-23 Price Elasticity and Total Expenditure Movie ticket price increases from $8 to $10 –Prices are both above the midpoint of the curve Elastic portion of the demand curve –Total revenue decreases D Expenditure = $1,600/day 12 Quantity (00s of tickets/day) Price ($/ticket) 26 8 Y Z D Expenditure = $1,000/day 12 Quantity (00s of tickets/day) Price ($/ticket) 16 10

4-24 Cross-Price Elasticity of Demand Substitutes and complements affect demand Cross-price elasticity of demand is defined as the percentage change in quantity demanded of good A from a 1 percent change in the price of good B Sign of cross-price elasticity shows relationship between the goods –Complements have negative cross-price elasticity –Substitutes have positive cross-price elasticity Income Elasticity of Demand Income elasticity of demand is defined as the percentage change in quantity demanded from a 1 percent change in income. Income elasticity of demand can be positive or negative. –Positive income elasticity is a normal good. –Negative income elasticity is an inferior good.