INTERMEDIATE MICROECONOMICS AND ITS APPLICATION

Name: INTERMEDIATE MICROECONOMICS AND ITS APPLICATION
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INTERMEDIATE MICROECONOMICS AND ITS APPLICATION
Chapter 4 Market Demand and Elasticity Copyright (c) 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida

Market Demand Curves The market demand is the total quantity of a good or service demanded by all potential buyers. The market demand curve is the relationship between the total quantity demanded of a good or service and its price, holding all other factors constant. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Construction of the Market Demand Curve
The market demand curve is constructed by horizontally summing the demands of the individual consumers Assume the market consists of only two buyers as shown in Figure 4.1 At any given price, such as P*X, individual 1 demands X*1 and individual 2 demands X*2. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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

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 Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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

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

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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. 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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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 Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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. 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. 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. 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. 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 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, eQ,P will be negative. For example, if eQ,P = -2, a 1 percent increase in price leads to a 2 percent decline in quantity. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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

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

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 Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

TABLE 4.2: Relationship between Price Changes and Changes in Total Expenditure

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

The Paradox of Agriculture
Good weather tends to produce bountiful crops, but very low crop prices. Bad weather can result in very high crop prices. Relatively small supply disruptions in the U.S. grain best during the early 1970s resulted in farm incomes rising more than 40 percent over a two year period. 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 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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Demand Curves and Price Elasticity
The relationship between a particular demand curve and the price elasticity it exhibits can be complicated. For some curves, the elasticity remains constant everywhere, but for others it is different at every point. A more accurate way to describe it would be to say the elasticity is for current prices. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Linear Demand Curves and Price Elasticity
The price elasticity of demand is always changing along a straight line demand curve. Demand is elastic at prices above the midpoint price. Demand is unit elastic at the midpoint price. Demand is inelastic at prices below the midpoint price. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Numerical Example of Elasticity on a Straight Line Demand Curve
Assume a straight-line demand curve for Walkman cassette tape players is Q = P where Q is the quantity of players demanded per week and P is their price. This demand curve is illustrated in Figure 4.3 and Table 4.3 shows several price-quantity combinations. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

FIGURE 4.3: Elasticity Varies along a Linear Demand Curve
Price (dollars) 50 40 30 25 Demand 20 10 20 40 50 60 80 100 Quantity of Walkmans per week 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

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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

A Unitary Elastic Curve
Suppose the demand for Walkman Tape Players took the form The graph of this equation, shown in Figure 4.4, is a hyperbola. P·Q = $1,200 regardless of price so demand is unit elastic (-1) everywhere on the curve. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

General Formula for the Elasticity of a Hyperbola
If the demand curve takes the following form, the price elasticity of demand is equal to b everywhere on the curve. 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): Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

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

Cross-Price Elasticity of Demand
If the goods are substitutes, an increase in the price of one will cause buyers to purchase more of the substitute, so the elasticity will be positive. If the goods are complements, an increase in the price of one will cause buyers to buy less of that good and also less of the good they use with it, so the elasticity will be negative Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Empirical Studies of Demand: Estimating Demand Curves
Estimating a demand curve for a product is one of the more difficult but important problems in econometrics. Empirical studies are useful because they a provide a more precise estimate of the amount of change in quantity demanded that results due to a price change. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Problems Estimating Demand Curves
The first problem is how to derive an estimate holding all other factors (the ceteris paribus assumption) constant. This problem is often solved, as discussed in the Appendix to Chapter 1, by the use of multiple regression analysis. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Problems Estimating Demand Curves
The second problem deals with what is observed in the data. The data points represent quantity and price outcomes that are simultaneously determined by both the demand and the supply curves. The econometric problem is to “identify” from these equilibrium points the demand curve that generated them. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Some Elasticity Estimates
Table 4.4 gathers a number of estimated income and price elasticities of demand. Some things to note All of the estimated price elasticities are less than zero as predicted by a negatively sloped demand curve. Most of the price elasticity estimates are inelastic. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

TABLE 4.4: Representative Price and Income Elasticities of Demand

Some Elasticity Estimates
The income elasticities of automobiles and transatlantic travel exceed 1 (luxuries). The high income elasticities are balanced by goods such as food and medical care which are less than 1 (necessities). There is no evidence of Giffen’s paradox in the table. 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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

TABLE 4.5: Representative Cross-Price Elasticities of Demand

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. 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? Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

Low Elasticities for Hospital and Doctors’ Visits
Using the estimate of 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. 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. Copyright (c) 2000 by Harcourt, Inc. All rights reserved.

INTERMEDIATE MICROECONOMICS AND ITS APPLICATION

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