1. Chapter 4 – Product Market Demand zThis chapter examines the major causes of the Demand for a specific good – its own price, the prices of related goods, tastes, and consumer income. zAlso we distinguish between the qualitative (direction of change) versus the quantitative (elasticity) effects of a ceteris paribus change in each of these causes.

2. Price and Quantity Demanded: Direction of Change zRecall – the good’s own price (P) is a cause of quantity demanded of that good (Q). zQualitative Effect: P   Q D . zQualitative Effect – measures direction of change.

3. Underlying Reason: Inverse Relationship zConsumer maximizes utility subject to their budget constraint when MU 1 /P 1 = MU 2 /P 2 = … zIf P 1 , then consumer should rebalance by MU 1  to make the ratio equal across goods again. zGiven diminishing Marginal Utility, this is done by having Q 1 .

4. Own Price Elasticity of Demand zOwn Price Elasticity of Demand (  ) – measures the magnitude of responsiveness of quantity demanded of a good to changes in its own price. In other words, the Quantitative Effect of a change in price on the quantity demanded of that good.

5. Own Price Elasticity of Demand (  ): A Formula  = |Percentage Change in Q D | |Percentage Change in P|. Always has positive sign. Ratio of percentage changes instead of slope, makes it a unit-free measure.

6. Price Inelastic Goods zPrice Inelastic Goods have  < 1. These goods are unresponsive to changes in their own price. Example – suppose that if the Price of Milk increases by 10%, Quantity Demanded of Milk goes down by 3%. Then, for Milk,  = |-3%|/|10%| = 0.3.

7. Price Elastic Goods and Unitary Price Elasticity zPrice Elastic Goods have  > 1. These goods are responsive to changes in their own price. Example – suppose that if the Price of Cars increase by 10%, Quantity Demanded of Cars goes down by 18%. Then, for Cars,  = |-18%|/|10%| = 1.8. zUnitary Price Elasticity:  = 1.

8. What Features Make Goods Price Inelastic or Elastic? zNecessity versus Luxury zNumber and Quality of Available Substitutes zTime Frame zPrice Relative to Wealth or Income

9. Own Price Elasticity: The Demand Curve zPrice Inelastic goods are described with steep demand curves. The vertical demand curve is the extreme case of  = 0. zPrice Elastic goods are described with flat demand curves. The horizontal demand curve is the extreme case of  = .

10. Own Price Elasticity and Equilibrium zConsider an equilibrium, where Demand equals Supply. zSupply shifts (rightward or leftward) change the equilibrium, accomplished by moving along the existing demand curve. zTherefore the new equilibrium quantity can be compared to the original one by means of own price elasticity.

11. Own Price Inelasticity and Total Revenue of Firms zTotal Revenue (TR) = (Price of Good)x(Quantity Sold), or TR = PxQ. zThis relationship implies that, in percentage change terms: (% Change in TR) = (% Change in P) + (% Change in Q).

12. Own Price Elasticity and Increasing the Price zConsider our two goods: milk (  = 0.3), and cars (  = 1.8). Suppose that supply shifts so that the price of each increases by 10%. z% Change in TR of Milk = 10% + -3% = 7%. z% Change in TR of Cars = 10% + -18% = -8%.

13. Own Price Elasticity and Decreasing the Price zConsider again our two goods: milk (  = 0.3), and cars (  = 1.8). Suppose supply shifts so that the price of each decreases by 10%. z% Change in TR of Milk = -10% + 3% = -7%. z% Change in TR of Cars = -10% + 18% = 8%.

14. Application: What Goods Should Have a Sales Tax? zSales tax – tax on supply. zFirms try to pass it on to consumers. zConsider the contrast between a sales tax on a price inelastic good versus a sales tax on a price elastic good. zWhat is the government’s goal – collect tax revenue or significantly reduce the quantity traded?

15. Another Cause of Demand – Prices of Related Goods zConsider, for example, the Demand for Coffee. zAffected by prices of related goods in two different ways. -- P DONUTS   Q COFFEE  (Complements) -- P TEA   Q COFFEE  (Substitutes)

16. Cross Price Elasticity zCross Price Elasticity (  1x2 ) – measures the responsiveness of demand to changes in the prices of complements or substitutes.  1x2 = Percentage Change in Q 2 Percentage Change in P 1.

17. Interpreting Cross Price Elasticity z  1x2 = Percentage Change in Q 2 Percentage Change in P 1. zSign of  1x2 describes whether the related good is a complement (negative) or substitute (positive). zAbsolute Value of  1x2 describes the magnitude of response. |  1x2 | 1 describes an elastic response.

18. Cross Price Elasticity: A Numerical Example zSuppose that, for coffee:  DONUTSxCOFFEE = -0.4 Negative sign  Donuts are a complement. Absolute value < 1  Inelastic, or unresponsive.  TEAxCOFFEE = 1.5 Positive sign  Tea is a substitute. Absolute value > 1  Elastic, or responsive.

19. Cross Price Elasticity and Dependence of Markets zConsider the markets (i.e. Demand and Supply) for Gasoline, Cars, and Ethanol. zGasoline and Cars are Complements (P GAS   Q CARS  ). zGasoline and Ethanol are Substitutes (P GAS   Q ETHANOL  ).

20. Cross Price Elasticity and Dependence of Markets zSuppose the government decides to put a substantial sales tax on gasoline (or another supply disruption). zDecreases supply of gasoline, described by shifting supply curve for gas leftward  P* GAS , Q* GAS .

21. Cross Price Elasticity and Dependence of Markets zThe move also has effects in the markets for cars and ethanol. zDecreases demand for cars, described by shifting the demand curve for cars leftward  P* CARS , Q* CARS . zIncreases demand for ethanol, described by shifting the demand curve for ethanol rightward  P* ETHANOL , Q* ETHANOL . zCross Price Elasticity – describes size of shifts for cars and electricity.

22. Another Cause of Demand – Consumer Income zThe Demand for most goods is affected by changes in the consumer’s income (I). -- I   Q  (Normal Goods) -- I   Q  (Inferior Goods)

23. Income Elasticity zIncome Elasticity (  I ) – measures the responsiveness of demand to changes in consumer income.  I = Percentage Change in Q D Percentage Change in I.

24. Interpreting Income Elasticity z  I = Percentage Change in Q D Percentage Change in I. zSign of  I describes whether the good is a normal good (positive) or inferior good (negative). zAbsolute Value of  I describes the magnitude of response. |  I | 1 describes an elastic response.

25. Income Elasticity: A Numerical Example zSuppose that: For Tuna Helper,  I = -1.4. Negative sign  inferior good. Absolute value > 1  Elastic, or responsive. For Apples,  I = 0.5. Positive sign  normal good. Absolute value < 1  Inelastic, or unresponsive.

26. Income Changes: Graphical Description zSince income is “another cause” of demand, changes in income are described as shifts of the demand curve. zSince it shifts the Demand curve, changes in consumer income affect P* and Q* as well.

27. Income Changes: Graphical Description zFor normal goods (  I > 0), I   Q D . zTherefore, one describes an increase in income as a rightward shift in the demand curve. zFor inferior goods (  I < 0), I   Q D . zTherefore, one describes an increase in income as a leftward shift in the demand curve. zAbsolute value of income elasticity describes size of shift.

28. Individual Versus Market Demand zThe Market Demand for any good is obtained by summing up the individual demands for all the consumers for this good. zExample – consider the demand for apples. zSuppose the demanders consist of two people, me and you.

29. Demand for Apples Price ($) Me + You = Market 0.20 25 8 33 0.25 23 7 30 0.30 21 6 27 0.35 19 5 24 0.40 17 4 21 0.45 15 3 18

30. Causes: Market Demand For a Good zPrice of Good zPrice of Related Goods (Substitutes or Complements) zConsumer Income (Normal or Inferior Good) zTastes zNumber of buyers in the market (Market Demand only)

31. Demographics and Market Demand for Goods zChanging population needs and preferences lead to changes in the number of participants. zExample – aging of baby boomers. zDecreases in market demand (shifts leftward) for fast food, adult soccer leagues, starter homes. zIncreases in market demand (shifts rightward) for fresh fruits, walking sneakers, retirement condos.