1. Market Demand and Elasticity
Chapter 4
Market Demand and Elasticity

2. 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.

3. Construction of the Market Demand Curve
The market demand curve is constructed by horizontally summing the demands of the individual consumers

4. FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves
At any given price, such as P*X, individual 1 demands X*1 and individual 2 demands X*2. PX PX PX P* X D X* X* X* X 1 2
(a) Individual 1
(b) Individual 2
(c) Market Demand
The total quantity demanded at the market at P*X is the sum of the two amounts: X* = X*1 + X*2 .

5. Shifts in the Market Demand Curve
To discover how some event might shift a market demand curve, we must:
find out how this event causes individual demand curves to shift
compare the horizontal sum of these new demand curves with the old demand curve.

6. FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward
(b) Individual 2
(a) Individual 1
(c) Market Demand PX D’ PX PX D P* X X*
X** X*
X** X*
X** X 1 1 2 2
An increase in income for each consumer would shift their individual demand curves out so that the market demand curve, would also shift out.

7. 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.
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.

8. Substitutes and Complements
Changes in the prices of related goods, substitutes or complements, will also shift the individual and market demand curves.
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.

9. APPLICATION 4.1: The 2001 Tax Cut
People’s ability to purchase 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.
One-time increase in income will not stimulate spending
Major tax cuts announced in 2001 to counter recession
Every taxpayer received $300 in 2001, but these checks were mostly saved

10. APPLICATION 4.1: Consumption and Income Taxes
Timing of tax cuts
Most cuts deferred until
Present value: small in 2001, spending does not increase
Credibility: hard to believe the government will live up to its promises to cut taxes eight years later
Complexity of income tax
“Sunset” provisions: return to 2001 levels after 2011
AMT (alternative minimum tax) rate increases
Many tax reductions in the form of specific credits e.g. tuition fees, energy conservation etc

11. A Word on Notation and Terms
Q & P: When looking at only one market, Q is used for the quantity of the good demanded, and P is used for its price.
Ceteris Paribus: When drawing the demand curve, all non-price factors are assumed to not change.
Demand and Quantity Demanded: Movements along the curve are changes in quantity demanded, while shifts are changes in demand.

12. 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.

13. 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.

14. 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

15. 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 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.

16. 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.

17. TABLE 4.1: Terminology for the Ranges of eQ,P

18. 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.

19. 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.

20. 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.
Price elasticity is mostly affected by the substitution effect

21. 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.
Substitution effects are stronger in the long-run compared to the short-tun.

22. APPLICATION 4.2: Brand Loyalty
Reduce opportunity costs of constant re-evaluation
Makes consumer insensitive to (small) price differentials
Is more likely to change in the long-run
Automobiles
Loyalty to US cars prior to 1980s
After 1980s developing loyalty to Japanese cars
US automakers increase size of US cars to compete
Estimates: $1600 (in 1991) price reduction on US cars would make customers loyal to Japanese cars switch

23. APPLICATION 4.2: Brand Loyalty
Licensing of Brand Names
Makes products less substitutable with goods of similar price-quality ratio
Coca-Cola blue jeans
Mickey-Mouse handbags etc
Overcoming Brand Loyalty
Consumers face “switching costs” when they try a new loyalty
Producers
Offer temporary price discounts
Engage in heavy advertizing
Shum (2004): Advertizing is less costly for the same effect compared to temporary price reductions

24. 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.

25. Price Elasticity and Total Expenditures
Suppose price elasticity = -2.
Suppose people buy 1 million automobiles at $10000 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

26. 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.

27. 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.
A 20 percent price increase to $3.60 means quantity falls by 10 percent to 90 million with total expenditures now equal to $324 million.

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

29. 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.

30. 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 belt during the early 1970s resulted in farm incomes rising more than 40 percent over a two year period.
When good weather returned, prices quickly fell back
Bad weather is often actually good news for the farmers!

31. Volatile Prices and Government Programs
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
Subsidies to keep farmland fallow
The federal government purchased crops outright
Federal Agricultural Improvement and Reform Act (FAIR)
Reduced government intervention
Factors mitigating the FAIR act
Bad weather: Katrina etc
Elections in 2002

32. 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 that elasticity is NOT the slope, in general varying along the demand curve.

33. 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.

34. Numerical Example of Elasticity on a Straight Line Demand Curve
Assume a straight-line demand curve is Q = P

35. FIGURE 4.3: Elasticity Varies along a Linear Demand Curve
Price
For prices of $50 or more, nothing is bought so total expenditures are $0.
(dollars) 50
As prices fall between $50 and $25, the midpoint, total expenditures increase. 40
At the midpoint, total expenditures reach a maximum. 30 25
As prices fall below $25, total expenditures also fall. 20 10 20 40 50 60 80
100
Quantity

36. Elasticity of a Straight Line Demand Curve
More generally, for a linear demand curve of the form Q = a - bP,

37. A Unitary Elastic Curve
Suppose the demand for tape players took the form
P·Q = $1,200 regardless of price so demand is unit elastic (-1) everywhere on the curve.

38. FIGURE 4.5: A Unitary Elastic Demand Curve
Price
(dollars) 60 50 40 30 20 20 24 30 40 60
Quantity of
tape players
per week

39. 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.

40. 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):

41. 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.

42. APPLICATION 4.4: An Experiment in Health Insurance
U.S. has several medical insurance policies
Medicare: insurance for the aged
Medicaid: insurance for the poor
Common problem for any medical insurance scheme
Moral hazard
Insurance coverage increases demand for health services
Korea: can’t go to the university hospital before visiting a small one

43. Rand Corporation Experiment
How large are the effects of moral hazard going to be?
Medicare introduced in 1965
Increase in demand by the elderly immediate
Rand Corporation experiment
Coinsurance rate varied from zero to almost 100%
Experiment conducted in four cities

44. Table 1: Results of the Rand Health Insurance Experiment

45. The Rand Experiment
A rough estimate of the elasticity of demand can be obtained by averaging the percentage changes across the various plans in Table 1
The average extent of moral hazard effects has been found to be small
Dental care and mental health care are different since demand for these services has been found to be elastic

46. 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,

47. 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.

48. 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 provide a more precise estimate of the amount of change in quantity demanded that results due to a price change.

49. 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.

50. 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.
Do the observed combinations of prices and quantities belong to the same, or to several different demand curves?

51. TABLE 4.4: Some Elasticity Estimates

52. 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.

53. Some Cross-price Elasticity Estimates
All of the goods appear to be substitutes and have positive cross-price elasticities.
Demand for
Effect of Price of
Elasticity Estimate

54. Application 4.5: Alcohol Taxes as Drunk Driving Policy
Each year more than 40,000 Americans die in automobile accidents.
It is generally believed that alcohol consumption is a major contributing factor in at least half of those accidents.
Most empirical studies of alcohol consumption show that it is sensitive to price.
Government policies
Increasing legal driving age
Adopting stricter drunk-driving laws

55. Application 4.5: Alcohol Taxes as Drunk Driving Policy
How is teen alcohol consumption related to alcohol taxes?
Price elasticity of beer is less than half that of wine
Most teen alcohol consumption is beer
More alcohol taxes will have little effect on teens
Why is price elasticity of demand for beer so low?
Group drinking: marginal cost of one more drink is zero once the keg is there
Preferences: most beer consumers drink more than habitually
However, binge drinking may be a habit that takes time to form
In the longer run, elasticity of beer demand may be higher than the short-run estimates imply