# Introduction to microeconomics Demand relationships Chapter 4.

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Introduction to microeconomics Demand relationships Chapter 4

Learning Goals Understand the nature of demand Identify optimum spending for a good in the face of a budget constraint Define the price elasticity of demand Describe the effects of a change in price and income (substitution and income effects) Calculating market demand Define income and cross-price elasticity

Demand curve is a relationship between the quantity demanded and its price. Law of Demand The Law of Demand – Other things remaining equal – Other things remaining equal, price and quantity demand will be inversely related. – the cost of consuming good or service is the sum of all the sacrifices needed to consume – The price of good A is the amount of another good (B)needed to gain the exclusive right to consume – Most often use a common good B to measure price (money) The Law of Demand © 2012 McGraw-Hill Ryerson Limited Ch4 -3 LO3: Derive a Demand Curve

Utility – the satisfaction derived from consuming a good or service. Utility Maximization – economists assume people try to allocate choose a set of goods to maximize their satisfaction. Util – a fictional unit of pleasure or utility obtained from an item. Utility © 2012 McGraw-Hill Ryerson Limited Ch4 -4 LO1: Derive Rational Spending Rule

Total utility increases with each cone eaten, up to the fourth cone/per hour. © 2012 McGraw-Hill Ryerson Limited Cone quantity (cones/hour) Total utility (utils/hour) 00 1100 2150 3175 4187 5184 Marginal utility typically declines and then becomes negative Total utility increases and then falls The marginal utility of ice cream consumption (cones/hour) declines with number of cones eaten per hour Marginal utility switches from + to – at the same point where total utility starts to decline.

Cone quantity (cones/hour) Total utility (utils/hour) Marginal utility (utils/cone) 00 1100 2150 3175 4187 5184 LO1: Derive Rational Spending Rule Total Utility from Ice Cream Consumption Marginal utility = change in utility/change in consumption © 2012 McGraw-Hill Ryerson Limited Ch4 -6 100 50 25 12 -3 Why do we need cones/hour and not just cones? What does the marginal marginal utility measure?

Diminishing marginal utility – As the consumption of a good or service increases, the additional utility gained from an extra unit of the commodity tends to decline. – Based on the cost-benefit principle, you continue to order cones as long as the marginal utility from an additional cone is greater or equal to zero. – This assumes no budget constraint or any other good (substitute – chocolate cake) or complement (apple pie)

You have an income of \$10 per week to spend on two types of ice-cream. Cones costs \$1; Sundaes costs \$2 © 2012 McGraw-Hill Ryerson Limited Ch4 -8 LO1: Derive Rational Spending Rule Cone/sundae combinations Total utility (utils/week) 10 cones, 0 sundaes80 + 0 = 80 8 cones, 1 sundae82 + 50 = 132 6 cones, 2 sundae80 + 80 = 160 4 cones, 3 sundae68 + 105 = 173 2 cones, 4 sundae50 + 120 = 170 0 cones, 5 sundaes0 + 130 = 130 Optimal combination of goods The Optimal combination of goods is the Affordable combination that delivers maximum total utility

The Rational Spending Rule I © 2012 McGraw-Hill Ryerson Limited Ch4 -9 LO1: Derive Rational Spending Rule The marginal utility for the 3 rd sundae is 25 utils (105-80 = 25 utils), and the marginal utility per dollar is 12.5 utils (25/\$2 = 12.5). If you spends \$2 for cones instead (buying the 5 th and the 6 th cone), it will increase your total utility by 12 utils ( 5 th cone: 75-68 = 7 utils; 6 th cone: 80- 75 = 5 utils). You are is getting more utils per dollar from the last sundae you purchases than from the last cone, then you will buy more sundae.

Allocate spending across goods so that the marginal utility per dollar is the same for each good. The marginal utility per dollar = Follows directly from the cost /benefit (here the benefit/cost)principle. To maximize benefit (utility), the ratio of marginal utility to price must be the same for each good the consumer buys. The Rational Spending Rule II © 2012 McGraw-Hill Ryerson Limited Ch4 -10 LO1: Derive Rational Spending Rule

A demand curve emerges from constrained choices If income rises from \$10 to \$14 per week, then …? – Extra income stimulates demand by enlarging the set of affordable combinations. If the price of cones rises to \$2 rather than \$1, then …? – At \$1 per cone, marginal utility per dollar is 8 utils/dollar and you buy 4 cones/week. – At \$2 per cone, marginal utility per dollar is 4 utils/dollar, you only buy 1 cone/week. By applying the rational spending rule to price changes, a demand curve emerges

As price of the cone increases from \$1 to \$2, applying the rational spending rule to the utility schedule, the demand for cone has decreased from 4 to 1. Demand for Vanilla Cones 34 2.00 1.50 Quantity (cones/week) Price (\$/cone) 1.00 12 D © 2012 McGraw-Hill Ryerson Limited Ch4 -12 LO3: Derive a Demand Curve

Income effect: the change in quantity demanded of a good that occurs because a change in the price of the good changes the effective income of the purchaser. – A cone at \$1, allows you to maximize total utility by spending \$10 to purchase 4 cones and 3 sundaes per week. – A cone at \$2, requires \$14 to buy the previous combination, therefore effective income falls. Substitution effect: the change in quantity demanded of a good whose relative price has changed while a consumers real income is held constant. – When the price of a cone increases, rational consumers substitute the good that has the relatively lower price. Income and Substitution Effect © 2012 McGraw-Hill Ryerson Limited Ch4 -13 LO4: Income and Substitution Effect

Individual and Market Demand Curves - Tuna Market demand curve © 2012 McGraw-Hill Ryerson Limited

Private good (consumption) Total market demand for a private good is the horizontal sum of individual demand. Utility for the consumer is derived solely from his/her personal consumption Private goods involve no sharing of utility (or disutility) among consumers – The smell of tuna on Smiths breath does not repel Wong – Wong is not overjoyed at finding a fellow tuna eater – Singh does not worry that Smith and Wong are eating an endangered species

P D is for the price of the good. Q D is for the quantity demanded. c is the horizontal intercept of the demand curve or….? ----------> Consumption when price (PD) is zero (free). – -d represents the reciprocal of the slope. Equation for a Straight Line Demand Curve © 2012 McGraw-Hill Ryerson Limited Ch4 -16 LO3: Derive a Demand Curve

The Market Demand Curve for Canned Tuna © 2012 McGraw-Hill Ryerson Limited Ch4 -17 LO3: Derive a Demand Curve

Total Expenditure equals – The number of units bought multiplied by the price of the good. Total Expenditure of consumers = Total Revenue of Producers Total Expenditure © 2012 McGraw-Hill Ryerson Limited Ch4 -18 LO3: Derive a Demand Curve

FIGURE 4.7 The Demand Curve for Movie Tickets 0123456 2 4 6 8 10 12 D Quantity (100s of tickets/day) Price (\$/ticket) An increase in price from \$2 to \$4 per ticket increases total expenditure on tickets © 2012 McGraw-Hill Ryerson Limited Ch4 -19 LO3: Derive a Demand Curve Common area New area gained > old area lost

FIGURE 4.8 The Demand Curve for Movie Tickets Losses in total expenditure Quantity (100s of tickets/day) (a) Quantity (100s of tickets/day) (b) Price (\$/ticket) 14 12 10 8 6 4 2 0 14 12 10 8 6 4 2 0123456123456 An Increase in price from \$8 to \$10 per ticket results in a fall in total expenditure on tickets. © 2012 McGraw-Hill Ryerson Limited Ch4 -20 Increase in total expenditure

Definition: The percentage change in the quantity of a good demanded resulting from a one-percent change in its own price. Elastic Demand – price elasticity is greater than one. – Price increases/decreases, quantity demanded falls/rises Inelastic Demand – price elasticity is less than one. – Price increases/decreases, quantity demanded rises/falls Unitary elastic demand – price elasticity equals one – A transition point on every demand Own Price Elasticity of Demand © 2012 McGraw-Hill Ryerson Limited Ch4 -21LO5: Interpret Elasticities

Price elastic products: Quantity demanded is highly responsive to price changes. Price inelastic: Quantity demanded is not responsive to price changes. Price Elasticity and Expenditures © 2012 McGraw-Hill Ryerson Limited Ch4 -22LO5: Interpret Elasticities ε>1P R ε=1P R ε<1P R Inelastic demand: Apple iPhone 5 Elastic demand: Fast Food

Will a higher tax on cigarettes curb teenage smoking? Peer influence is the most important determinants of teen smoking. Most teenagers have small disposable incomes, cigarettes are usually large share of a teenage smokers budget. The price elasticity of demand for teens is likely to be fairly high Therefore: A higher tax should make smoking less affordable for some teenagers. How does this apply to hard drugs? Are these price elastic or inelastic? What does a company do to reduce the elasticity of demand for its products? What does government do to increase the price elasticity of demand for cigarettes? View notes page

Good or servicePrice elasticity Green peas2.80 Restaurant meals1.63 Automobiles1.35 Electricity1.20 Beer1.19 Movies0.87 Air travel (foreign)0.77 Shoes0.70 Coffee0.25 Theatre, opera0.18 Some Representative Elasticity Estimates © 2012 McGraw-Hill Ryerson Limited Ch4 -24LO5: Interpret Elasticities Why are theatre tickets so inelastic? Why are green peas elastic?

– the percentage change in the quantity of a good demanded resulting from a one-percent change in its price. Price elasticity = % change in quantity demanded / % change in price. ε = (ΔQ/Q)/(ΔP/P). – Since the slope of the demand curve is ΔP/ΔQ, another way to express it is: ε = (P/Q)(1/slope). Price elasticity of demand is defined as: © 2012 McGraw-Hill Ryerson Limited Ch4 -25LO6: Calculate Elasticities

Graphical Interpretation of Price Elasticity of Demand © 2012 McGraw-Hill Ryerson Limited Ch4 -26LO6: Calculate Elasticities

Calculating Price Elasticity of Demand ε = (P/Q)(1/slope) Slope is the ratio of its vertical intercept to its horizontal intercept. Slope = 20/5 = 4 ε A = (8/3)(1/4) = 2/3 ε B = (12/2)(1/4) = 3/2 © 2012 McGraw-Hill Ryerson Limited Ch4 -27 LO6: Calculate Elasticities The elasticity of demand varies along the demand curve It is lowest (less elastic or more inelastic) at higher than lower prices Slope (steepness of the demand) is only part of the story.

The slope of a straight line demand curve is constant. The price-quantity ratio declines as we move down the demand curve. Price elasticity declines as we move down the demand curve. As price increases, quantity demanded increases as does total expenditures until it reaches a maximum when elasticity equals one. Total expenditure begins to decreases as quantity continues to increases, until it reaches zero. Elasticity and Total Expenditure LO6: Calculate Elasticities © 2012 McGraw-Hill Ryerson Limited ε declines

Price Elasticity of Demand and Total Expenditure LO6: Calculate Elasticities As price declines, quantity demanded increases, total expenditure increases until it reaches a maximum of \$18, then decreases until price is zero. © 2012 McGraw-Hill Ryerson Limited Ch4 -29

When Price and quantity are the same, price elasticity of demand is always less for the steeper of the two demand curves. The Relationship between Slope and Elasticity LO6: Calculate Elasticities At point A, P/Q is the same for both curved; but D2 is steeper, D2 is less elastic than D1 at point A © 2012 McGraw-Hill Ryerson Limited Ch4 -31

Perfectly Elastic demand – Price elasticity of demand is infinite. – Even the slightest change in price leads consumers to find substitutes. (All fast food is equally disgusting) Perfectly Inelastic demand – Price elasticity of demand is zero. – Consumers do not switch to substitutes even when price increases dramatically (Often substitutes do not exist). Unit Elastic demand – Regardless of the price selected, total expenditure is unchanged. Three Special Cases © 2012 McGraw-Hill Ryerson Limited Ch4 -32LO5: Interpret Elasticities

Perfectly Elastic, Perfectly Inelastic, and Unit Elastic Demand Curves © 2012 McGraw-Hill Ryerson Limited Ch4 -33LO5: Interpret Elasticities Q D = 1/P D

The percentage amount by which the quantity demanded changes in response to a one-percent change in income. – Normal good: a good with a positive income elasticity of demand. – Inferior good: a good with negative income elasticity of demand. – Luxury good: a good with an income elasticity of demand greater than one; a subset of normal good. Income Elasticity of Demand © 2012 McGraw-Hill Ryerson Limited Ch4 -34 LO6: Calculate Elasticities

The strange story of the Giffen good Giffen good: people consume more as the price rises, apparently violating the law of demand. In most cases, substitution dominates demand – price rises lead to reductions in quantity demanded For a Giffen good, income effects dominate – price rises reduce effective income, and in certain cases where the good is a necessity (staple foods for low income families) Example: If the price of Kraft dinner rises, a low income family experiences a loss of effective income, and to maintain calories, cuts back on the consumption more expensive goods. All Giffen goods are inferior goods but not all inferior goods are Giffen goods. Why not? As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it. Source: A. Marshall, Principles of Economics, 3 rd ed.

Experience, credence, post-experience and Veblen goods Experience good: A good whose value can only be determined on consumption (Example: restaurant meal) Search Good: A good whose value can be determined in advance of consumption (Example: computer) Credence goods: Goods that are hard to assess even on consumption (repairs, medical treatment, vitamin supplements…) Veblen goods: Goods consumed as status symbols (a form of luxury good).

– The percentage amount by which the quantity demanded of one good changes in response to a one-percent change in the price of another good – Substitutes: two goods whose cross-price elasticity is positive – Complements : two goods whose cross-price elasticity is negative Cross Price Elasticity of Demand © 2012 McGraw-Hill Ryerson Limited Ch4 -37 LO6: Calculate Elasticities

Price increase will – increase total expenditure if demand is inelastic – but reduce it if demand is elastic. Price elasticity varies with price and along the demand curve Price change is the main independent variable Price changes have two main effects – Income effect (price increases/decreases lead of decreases/increases in effective income) – Substitution effects (price increases/decreases force the consumer to manage a fixed income by decreases/increases) in consumption Benefit/cost principle of consumer demand – Conmsumers increase spending on a good as long as marginal utility is higher than price – Spending is allocated among goods to equate the ratios of respective marginal utilities to prices Total expenditure on a good reaches a maximum when price elasticity of demand is equal to one. The price elasticity of demand at a point – ε = (ΔQ/Q)/(ΔP/P) or ε = (P/Q)(1/slope). Income elasticity of demand is the percentage change in quantity demanded of good that arises from a 1 percent change in income. Cross-price elasticity of demand is the percentage change in quantity demanded of a good that arises from a 1 percent change in the price of a different good. Chapter Summary © 2012 McGraw-Hill Ryerson Limited Ch4 -38